
[Federal Register: September 3, 2009 (Volume 74, Number 170)]
[Notices]               
[Page 45663-45666]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr03se09-80]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-60584; File No. SR-ISE-2009-35]

 
Self-Regulatory Organizations; International Securities Exchange, 
LLC; Order Granting Approval of Proposed Rule Change Relating to 
Qualified Contingent Cross Orders

August 28, 2009.

I. Introduction

    On June 15, 2009, the International Securities Exchange, LLC 
(``Exchange'' or ``ISE'') 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 provide for Qualified 
Contingent Cross Orders. The proposed rule change was published for 
comment in the Federal Register on June 26, 2009.\3\ The Commission 
received two comment letters in response to the proposed rule change 
\4\ and a comment response letter from the Exchange.\5\ This order 
grants approval of the proposed rule change.
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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. 60147 (June 19, 
2009), 74 FR 30651 (``Notice'').
    \4\ See letter from Angelo Evangelou, Assistant General Counsel, 
Chicago Board Options Exchange (``CBOE''), to Elizabeth M. Murphy, 
Secretary, Commission, dated July 16, 2009 (``CBOE Letter'') and 
letter from Gerald D. O'Connell, Chief Compliance Officer, 
Susquehanna International Group, LLP (``SIG''), to Elizabeth M. 
Murphy, Secretary, Commission, dated August 10, 2009 (``SIG 
Letter'').
    \5\ See letter from Michael J. Simon, Secretary and General 
Counsel, ISE, to Elizabeth M. Murphy, Secretary, Commission, dated 
August 20, 2009 (``ISE Letter'').
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II. Description of the Proposal

    The Exchange is currently a participant in the Plan for the Purpose 
of Creating and Operating an Intermarket Option Linkage (``Current 
Plan'').\6\ Subject to certain conditions, the Current Plan provides 
for a limited trade-through \7\ exemption for ``block trades'' which 
are trades that, among other things, consist of 500 or more contracts 
with a premium value of at least $150,000.\8\ The Commission recently 
approved the Order Protection and Locked/Crossed Market Plan (``New 
Plan''),\9\ which will replace the Current Plan. Unlike the Current 
Plan, however, the New Plan does not provide an exemption for block 
trades. The Exchange believes that the loss of the block trade 
exemption will adversely affect the ability of its members to effect 
large trades that are tied to stock, and is proposing a new order type, 
the Qualified Contingent Cross Order,\10\ which the Exchange proposes 
to implement contemporaneously with its New Linkage Rules.
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    \6\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000) (File No. 4-429).
    \7\ A trade-through is a transaction in a given options series 
at a price that is inferior to the best price available in the 
market (``Trade-Through''). See Section 2(21) of the New Plan and 
Section 2(29) of the Current Plan.
    \8\ Current Plan Section 2(3) and 8(c)(i)(C).
    \9\ See Securities Exchange Act Release No. 60405 (July 30, 
2009), 74 FR 39362 (August 6, 2009) (File No. 4-546). The Exchange 
has also proposed revisions to its rules to implement the New Plan 
(``New Linkage Rules''). See Securities Exchange Act Release No. 
60559 (August 21, 2009), 74 FR 44425 (August 28, 2009) (SR-ISE-2009-
27).
    \10\ Proposed ISE Rule 715(j), proposed Supplementary Material 
.01 to ISE Rule 715, and proposed ISE Rule 721(b).
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    The proposed Qualified Contingent Cross Order would permit an ISE 
member to cross the options leg of a Qualified Contingent Trade 
(``QCT'') \11\

[[Page 45664]]

on ISE immediately upon entry if the order is: (i) For at least 500 
contracts; (ii) part of a QCT; and (iii) executed at a price at or 
between the national best bid or offer (``NBBO'').\12\ Proposed 
Supplementary Material .01 to ISE Rule 715 defines a QCT as a 
transaction composed of two or more orders, executed as agent or 
principal, where: (i) At least one component is in an NMS stock; (ii) 
all components are effected with a product or price contingency that 
either has been agreed to by all the respective counterparties or 
arranged for by a broker-dealer as principal or agent; (iii) the 
execution of one component is contingent upon the execution of all 
other components at or near the same time; (iv) the specific 
relationship between the component orders (e.g., the spread between the 
prices of the component orders) is determined by the time the 
contingent order is placed; (v) the component orders bear a derivative 
relationship to one another, represent different classes of shares of 
the same issuer, or involve the securities of participants in mergers 
or with intentions to merge that have been announced or cancelled; and 
(vi) the transaction is fully hedged (without regard to any prior 
existing position) as a result of other components of the contingent 
trade.\13\
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    \11\ A Qualified Contingent Trade is a transaction consisting of 
two or more component orders, executed as agent or principal, that 
satisfy the six elements in the Commission's order exempting QCTs 
from the requirements of Rule 611(a) of Regulation NMS under the Act 
(``Regulation NMS''), which requires trading centers to establish, 
maintain, and enforce written policies and procedures that are 
reasonably designed to prevent trade-throughs. See Securities 
Exchange Act Release No. 57620 (April 4, 2008) 73 FR 19271 (April 9, 
2008) (``QCT Release''). See also Securities Exchange Act Release 
No. 54389 (August 31, 2006), 71 FR 52829 (September 7, 2006).
    \12\ Qualified Contingent Cross Orders will be automatically 
canceled if they cannot be executed. Proposed ISE Rule 721(b)(1).
    \13\ These requirements are substantively identical to those in 
the QCT Release, supra note 11.
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    The Exchange represents that it will adopt policies and procedures 
to ensure that its members use the Qualified Contingent Cross Order 
properly, including requiring them to properly mark such orders and 
instituting surveillance procedures to identify that the member 
executed the stock leg of the transaction at or near the same time as 
the options leg.

III. Discussion and Commission Findings

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities exchange 
and, in particular, with Section 6(b) of the Act.\14\ Specifically, the 
Commission finds that the proposal is consistent with Section 6(b)(5) 
of the Act,\15\ which requires, among other things, that the rules of a 
national securities 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. In addition, the 
Commission finds that the proposed rule change is consistent with 
Section 11A(a)(1)(C) of the Act,\16\ in which Congress found that it is 
in the public interest and appropriate for the protection of investors 
and the maintenance of fair and orderly markets to assure, among other 
things, the economically efficient execution of securities 
transactions.
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    \14\ 15 U.S.C. 78f(b). 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).
    \15\ 15 U.S.C. 78f(b)(5).
    \16\ 15 U.S.C. 78k-1(a)(1)(C).
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    In 2006, the Commission provided an exemption from Rule 611(a) of 
Regulation NMS for each NMS stock component of contingent trades that 
satisfied the six requirements for ``qualified contingent trades'' 
(``NMS QCT Exemption'').\17\ Pursuant to the Commission's exemption, 
trade-throughs caused by the execution of orders involving one or more 
NMS stocks that are components of a QCT are permitted. The Commission 
stated that QCT transactions that meet the specified requirements could 
be useful trading tools for investors and other market participants, 
and could be of benefit to the market as a whole, contributing to the 
efficient functioning of the securities markets and the price discovery 
process.\18\
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    \17\ See supra note 11.
    \18\ See QCT Release, supra note 11 at 19273.
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    As a result of the loss of the Trade-Through exemption for block 
trades that is available under the Current Plan, but not available 
under the New Plan, the Exchange has proposed the Qualified Contingent 
Cross Order, which it believes is necessary to facilitate the execution 
of large-sized stock-option orders. In particular, the Exchange stated 
that this proposed Qualified Contingent Cross Order is needed when the 
components of a stock-option are executed in separate markets, rather 
than as a package on options exchanges.\19\ The Exchange's proposal 
would provide for a new order type, the Qualified Contingent Cross 
Order, that would permit a cross of the options leg of a stock-option 
order that, among other things, met each of the six requirements of the 
NMS QCT Exemption.
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    \19\ Both the Current Plan and New Plan include a Trade-Through 
exception for ``complex trades,'' including stock-option orders 
represented as a package on options exchanges. See Section 
8(c)(iii)(G) of the Current Plan and Section 5(b)(viii) of the New 
Plan.
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    In its comment letter,\20\ CBOE asserted that the ISE proposal is 
misleading and has no relevance to the Trade-Through requirements of 
the New Plan because the proposed Qualified Contingent Cross Order 
would not violate the NBBO and therefore would not be in conflict with 
the New Plan. CBOE further questioned ISE's concern over losing the 
Trade-Through exemption for block trades. In particular, CBOE noted 
that, as with the Current Plan, the New Plan contains a Trade-Through 
exception for stock-option orders that are represented at a net 
price,\21\ and that this exception does not even require a 500-contract 
size minimum. In addition, CBOE noted that the NMS QCT Exemption, which 
CBOE believes only applies ``to stock-option trades negotiated and 
represented as a package,'' is also available to ISE members. Given 
these available alternatives, CBOE opined that it fails to follow ISE's 
statement that the proposal would ``provide customers with the 
flexibility needed to achieve their investment objectives.''
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    \20\ See CBOE Letter, supra note 4.
    \21\ i.e., the complex trade exception. See supra note 19.
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    ISE responded to CBOE's comments by affirming the close 
relationship between its proposal and the implementation of the New 
Plan because the New Plan does not contain the block trade exemption of 
the Current Plan. ISE stated the absence of a block trade exemption 
would make it very difficult for the options component of stock-option 
transactions to be executed without allowing such orders to be executed 
at a price that matches the NBBO. In particular, the Exchange explained 
that, for stock-option orders negotiated on a ``net price'' basis where 
such price reflects the total price of both the stock and options legs, 
``the actual execution price of each component is not as material to 
the parties as is the net price of the transaction.'' \22\ For a stock-
option order in which the stock leg meets the requirements of the NMS 
QCT Exemption, ISE noted that the stock leg can be executed at any 
price which in turn permits flexibility in the pricing of the options 
component as well, including allowing the options leg

[[Page 45665]]

to be priced between the Exchange's BBO. However, ISE noted that when 
its quotation spread was at the minimum increment, the options 
component would not be able to trade at a price between the ISE BBO. 
ISE also believed that its proposed Qualified Contingent Cross Order is 
more limited than the block trade exemption available under the Current 
Plan because trades would not be permitted to Trade-Through other 
markets, and would be limited to orders that meet the requirements of 
the NMS QCT Exemption.
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    \22\ See ISE Letter, supra note 5.
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    In addition, the Exchange disputed CBOE's assertion that the NMS 
QCT Exemption applied only to ``stock-option trades negotiated and 
represented as a package,'' noting that the NMS QCT Exemption contained 
no such limitation. Instead, the Exchange stated that stock-option 
orders, including those exempted from Rule 611(a) of Regulation NMS as 
qualified contingent trades under the NMS QCT Exemption, are regularly 
effected in the options markets ``without ever representing the legs 
together as one trade on an options exchange.'' The Commission agrees 
with the Exchange that the application of the NMS QCT Exemption to 
stock-option trades is not limited to those negotiated and represented 
as a package. So long as a transaction meets the six specified elements 
of the NMS QCT Exemption, the exemption is available for use by a 
trading center.
    In its comment letter,\23\ SIG stated that, if ISE's proposal were 
to be approved such that options legs of stock-option orders could be 
effected as clean option crosses without auction or exposure and ahead 
of other orders on ISE's book, the net result would be that customers 
would have little assurance that their stock-option orders are effected 
competitively or receive best execution prices. SIG, noting that ISE's 
proposal is modeled off of the NMS QCT Exemption, sought to provide 
context for which the Regulation NMS exemption was originally sought by 
the Securities Industry Association (``SIA'') (n/k/a SIFMA).\24\ SIG 
stated that SIA's exemption request presumed that the stock-option net 
price would be subject to competition (i.e., through the options 
markets) even if the stock leg were not, though it acknowledges that 
the Qualified Contingent Trade exemption provided by the Commission 
under Regulation NMS does not require exposure of such orders as a net 
trade. If it was envisioned that stock-option orders could be effected 
pursuant to ISE's proposal, ``with the stock leg at a trade-through 
price and the option leg at a book-priority price that was never 
exposed or auctioned,'' SIG believed that ``the conclusion would 
probably have been that there would be insufficient price discovery to 
merit an exemption for the stock leg.'' As such, SIG believed that 
ISE's proposal would strip away the price protections afforded by the 
options markets for stock-option orders and would result in their 
executions at non-competitive prices.\25\
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    \23\ See SIG Letter, supra note 4.
    \24\ Letter to Nancy M. Morris, Secretary, Commission, from 
Andrew Madoff, SIA Trading Committee, SIA, dated June 21, 2006 
(``SIA QCT Letter'').
    \25\ SIG also asserted that SIA only requested trade-through 
relief for one component order of a contingent trade (at least where 
there are only two legs involved). The Commission notes that the NMS 
QCT Exemption provides an exemption from Rule 611(a) for any, and 
not just one, Trade-Through that results from an execution of an 
order involving one or more NMS stocks that are components of a 
qualified contingent trade. See QCT Release, supra note 11.
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    As discussed above, the application of the NMS QCT Exemption to 
stock-option trades is not limited to those negotiated and represented 
as a package. In response to SIG, ISE also noted that the SIA's 
exemption request was focused solely on the need for trade-through 
relief for the NMS stock components of QCTs. In addition, ISE pointed 
out that, at the time the Commission granted the NMS QCT Exemption, 
every option leg of a stock-option transaction of 500 contracts or more 
was also exempt from trade-through liability based on the application 
of the Current Plan's block trade exemption. Accordingly, although an 
option leg of a stock-option QCT would not have had an exception from 
exchange priority rules, block-sized transactions would have been 
permitted to trade-through the NBBO. ISE's Qualified Contingent Cross 
Order, by contrast, would provide intermarket price protection by 
trading at a price no worse than the NBBO, but would be excepted from 
intramarket priority rules.
    CBOE also argued against the proposal because it believed that the 
Qualified Contingent Cross Order would be the first time that an 
options market would be permitted to cross orders ``without exposure to 
market participants and ahead of resting public customer orders,'' 
which CBOE argued would be ``a significant departure from the 
established practice of auction and exposure in the options industry.'' 
CBOE believed that the Exchange's proposal would disadvantage resting 
public customer orders, including large-sized public customer orders, 
and would be harmful to options market structure.\26\
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    \26\ See CBOE Letter, supra note 4.
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    In response to this argument, ISE stated that customer orders on 
its book would not be disadvantaged because they would not be bidding 
and offering for the contingent trade that is being executed. ISE 
disputed CBOE's view of the execution of Qualified Contingent Cross 
Orders as ``trading ahead'' of customers on its book, and disagreed 
with what it believed CBOE implied, that an exchange must either 
maintain customer priority in all circumstances or adopt a market 
structure that does not provide customer priority in any circumstance, 
noting that CBOE's own rules permit the execution of one leg of a 
complex order at the same price as public customers on its book when 
another leg is executed at an improved price.
    The Commission agrees with CBOE that the Exchange's proposal would 
represent a change in certain long-held principles in the options 
markets because it would permit the execution of a cross order without 
requiring exposure or customer priority. The Commission continues to 
believe that exposure and customer priority play an important role in 
ensuring competition and price discovery in the options markets. At the 
same time, as discussed above, the Commission also continues to believe 
that qualified contingent trades that satisfy the requirements of the 
NMS QCT Exemption can benefit the market as a whole and contribute to 
the efficient functioning of the securities markets and the price 
discovery process.\27\ The Commission believes that the Exchange's 
proposal to establish a limited exception to priority and exposure 
principles is consistent with the Act because it is limited solely to 
the options legs of stock-option orders that: (1) Satisfy the 
requirements of the NMS QCT Exemption; (2) are for a size of at least 
500 contracts; and (3) are executed at or better than the NBBO.
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    \27\ See QCT Release supra note 11.
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    In its comment letter, CBOE also stated that, while there might be 
a time and place to discuss special handling treatment for extremely 
large option orders, such standards should ``be considered in a 
transparent and measured manner with input from all industry 
participants (as opposed to via a rule filing pretending to adopt some 
linkage-related functionality).'' In this regard, the Commission notes 
that the proposal was published for public comment as required under 
Section

[[Page 45666]]

19(b) of the Act \28\ and the rules thereunder, and that the Commission 
has received and considered the comments of those industry participants 
that sought to provide input regarding the proposal, including CBOE, a 
competitor of the Exchange, as well as SIG, a large participant in the 
options market.
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    \28\ 15 U.S.C. 78s(b).
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    The Commission believes that the Exchange's proposed new Qualified 
Contingent Cross Order is consistent with the Act, and will allow 
Exchange members to retain the flexibility needed to utilize the 
Commission's NMS QCT Exemption for qualified stock-option transactions 
that are not presented as a package on an options exchange, but instead 
where the options and stock components are executed in separate 
markets. As noted above, the Commission believes that contingent trades 
that meet the requirements of the NMS QCT Exemption may be useful 
trading tools for investors and other market participants, and may be 
of benefit to the market as a whole, contributing to the efficient 
functioning of the securities markets and the price discovery 
process.\29\ The Commission believes that, given the NMS QCT Exemption, 
the Exchange's proposal is consistent with the Act in that it seeks to 
address the execution of stock-option orders whose legs are executed 
separately rather than as a package while limiting such orders to QCTs 
with a size of at least 500 contracts that are executed at or between 
the NBBO.\30\
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    \29\ See QCT Release, supra note 11 and accompanying text.
    \30\ The Commission notes that an original single-sided customer 
order would not otherwise constitute a multi-component, fully hedged 
trade for purposes of ISE's proposed Qualified Contingent Cross 
Order solely by virtue of being hedged by the member representing 
the order. In such a case, the Commission does not believe that the 
execution of the options leg would qualify for the proposed 
Qualified Contingent Cross Order.
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    In approving the proposed rule change, the Commission notes the 
Exchange's representation that it will adopt policies and procedures to 
ensure that its members use the proposed order type properly, including 
requiring members to mark all Qualified Contingent Cross Orders as 
such. In addition, ISE has represented that it will implement 
surveillance procedures to identify that the member executed the stock 
leg of the stock-option transaction at or near the same time as the 
options leg. The Commission emphasizes that these are important 
measures that should help ensure that the proposed order type is 
employed properly.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\31\ that the proposed rule changes (SR-ISE-2009-35) be, and hereby 
is, approved.
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    \31\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\32\
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    \32\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-21223 Filed 9-2-09; 8:45 am]

BILLING CODE 8010-01-P
