
[Federal Register Volume 76, Number 175 (Friday, September 9, 2011)]
[Notices]
[Pages 55969-55976]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-23045]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-65256; File No. SR-C2-2011-008]


Self-Regulatory Organizations; C2 Options Exchange, Incorporated; 
Order Approving Proposed Rule Change to Establish a Pilot Program To 
List and Trade a p.m.-Settled Cash-Settled S&P 500 Index Option Product

September 2, 2011.

I. Introduction

    On February 28, 2011, C2 Options Exchange, Incorporated (the 
``Exchange'' or ``C2'') 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 permit the listing and trading 
of p.m.-settled, cash-settled options on the Standard & Poor's 500 
Index (``S&P 500''). The proposed rule change was published for comment 
in the Federal Register on March 8, 2011.\3\ The Commission received 
seven comment letters on the proposal, some of which urged the 
Commission to disapprove the proposal.\4\ C2 responded to the comment 
letters in a response letter dated April 20, 2011.\5\ To ensure that 
the Commission had sufficient time to consider and take action on the 
Exchange's proposal in light of, among other things, the comments 
received on the proposal, the Commission extended the time period in 
which to either approve the proposed rule change, disapprove the 
proposed rule change, or institute proceedings to determine whether to 
disapprove the proposed rule change, to June 6, 2011.\6\
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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. 64011 (March 2, 
2011), 76 FR 12775 (``Notice'').
    \4\ See Letters to Elizabeth M. Murphy, Secretary, Commission, 
from Randall Mayne, Blue Capital Group, dated March 18, 2011 and 
April 28, 2011 (``Mayne Letter 1'' and ``Mayne Letter 2''); Michael 
J. Simon, Secretary, International Securities Exchange, LLC 
(``ISE''), dated March 29, 2011 and May 11, 2011 (``ISE Letter 1'' 
and ``ISE Letter 2''); Andrew Stevens, Legal Counsel, IMC Financial 
Markets, dated March 24, 2011 (``IMC Letter''); John Trader, dated 
April 20, 2011 (``Trader Letter''); and JP, dated April 30, 2011 
(``JP Letter'').
    \5\ See Letter to Elizabeth M. Murphy, Secretary, Commission, 
from Joanne Moffic-Silver, Secretary, C2, dated April 20, 2011 (``C2 
Response Letter'').
    \6\ See Securities Exchange Act Release No. 64266 (April 8, 
2011), 76 FR 20757 (April 13, 2011).
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    In order to solicit additional input from interested parties, 
including relevant data and analysis, on the issues presented by C2's 
proposed rule change, on June 3, 2011, the Commission instituted 
proceedings to determine whether to approve or disapprove C2's 
proposal.\7\ In its order instituting the proceedings, the Commission 
specifically noted its interest in receiving additional data and 
analysis relating to the potential effect that proposed p.m.-settled 
index options could have on the underlying cash equities markets. In 
response to the proceedings, the Commission received an additional 
three comment letters on the proposal as well as a rebuttal letter from 
C2.\8\ This order approves the proposed rule change on a 14-month pilot 
basis.
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    \7\ See Securities Exchange Act Release No. 64599 (June 3, 
2011), 76 FR 33798 (June 9, 2011).
    \8\ See Letters to Elizabeth M. Murphy, Secretary, Commission, 
from Michael J. Simon, Secretary, International Securities Exchange, 
LLC dated July 11, 2011 (``ISE Letter 3''); William J. Brodsky, 
Chairman and Chief Executive Officer, C2, dated July 11, 2011 
(``CBOE Letter 3''); Thomas Foertsch, President, Exchange Capital 
Resources, dated July 11, 2011; and William J. Brodsky, Chairman and 
Chief Executive Officer, C2, dated July 25, 2011.
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II. Description of the Proposal

    The Exchange's proposal would permit it to list and trade cash-
settled S&P 500 index options with third-Friday-of-the-month 
(``Expiration Friday'') expiration dates for which the exercise 
settlement value will be based on the index value derived from the 
closing prices of component securities (``p.m.-settled''). The proposed 
contract (referred to as ``SPXPM'') would use a $100 multiplier, and 
the minimum trading increment would be $0.05 for options trading below 
$3.00 and $0.10 for all other series. Strike price intervals would be 
set no less than 5 points apart. Consistent with existing rules for 
index options, the Exchange would allow up to twelve near-term 
expiration months, as well as LEAPS. Expiration processing would occur 
on the Saturday following Expiration Friday. The product would have 
European-style exercise and would not be subject to position limits, 
though there would be enhanced reporting requirements.
    The Exchange proposes that the SPXPM product be approved on a pilot 
basis for an initial period of fourteen months. As part of the pilot 
program, the Exchange committed to submit a pilot program report to the 
Commission at least two months prior to the

[[Page 55970]]

expiration date of the program (the ``annual report''). The annual 
report would contain an analysis of volume, open interest, and trading 
patterns. The analysis would examine trading in the proposed option 
product as well as trading in the securities that comprise the S&P 500 
index. In addition, for series that exceed certain minimum open 
interest parameters, the annual report would provide analysis of index 
price volatility and share trading activity. In addition to the annual 
report, the Exchange committed to provide the Commission with periodic 
interim reports while the pilot is in effect that would contain some, 
but not all, of the information contained in the annual report. In its 
filing, C2 notes that it would provide the annual and interim reports 
to the Commission on a confidential basis.\9\
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    \9\ See Notice, supra note 3, at 12777.
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III. Comments Received

    In response to the initial notice of C2's proposal, the Commission 
received seven comment letters, some of which expressed concern with 
the proposal.\10\ One commenter specifically urges the Commission to 
disapprove the proposal.\11\ Commenters expressing concern with the 
proposal raised several issues, including: The potential for adverse 
effects on the underlying cash markets that could accompany the 
reintroduction of p.m. settlement; concern with the similarity (but 
lack of fungibility) between the existing S&P 500 index option traded 
on the Chicago Board Options Exchange, Incorporated (``CBOE'') and the 
proposed S&P 500 index option that would be traded on C2; the lack of 
proposed position limits for SPXPM; and issues regarding exclusive 
product licensing. Three commenters expressed support for the 
proposal.\12\
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    \10\ See Mayne Letter 1, ISE Letter 1, ISE Letter 2, and Trader 
Letter, supra note 4.
    \11\ See ISE Letter 1 and ISE Letter 2, supra note 4.
    \12\ See Mayne Letter 2, IMC Letter, and JP Letter, supra note 
4.
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    In the proceedings to determine whether to approve or disapprove 
the proposal, the Commission preliminarily summarized the issues raised 
by the commenters, and also set forth a series of questions and 
requests for data on the issue of p.m. settlement. In response to the 
proceedings, the Commission received three letters, including one from 
C2, one from ISE that expands on the concerns it previously raised and 
reiterates its recommendation for the Commission to disapprove the 
proposal, and one from a new commenter that supports the proposal 
because it will offer investors greater flexibility.\13\ The Commission 
also received an additional letter from C2 responding to the comments 
of ISE.\14\ The comments received are addressed below.
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    \13\ See ECR Letter, supra note 8.
    \14\ See C2 Rebuttal Letter, supra note 8.
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IV. Discussion and Commission Findings

    After careful consideration of the proposal and the comments 
received, 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,\15\ and, in particular, the requirements of Section 6 of the 
Act.\16\ Specifically, the Commission finds that the proposed rule 
change is consistent with Section 6(b)(5) of the Act,\17\ which 
requires that an exchange have rules designed to remove impediments to 
and perfect the mechanism of a free and open market and to protect 
investors and the public interest.
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    \15\ 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).
    \16\ 15 U.S.C. 78f.
    \17\ 15 U.S.C. 78f(b)(5).
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A. Relationship to the National Market System

    One commenter believes that separate a.m. and p.m.-settled S&P 500 
index options could potentially bifurcate the market for CBOE's 
existing a.m.-settled SPX contract.\18\ This commenter notes that the 
SPX, which trades only on CBOE, accounts for 60% of all index options 
trading, and argues that the sole difference in settlement between SPX 
on CBOE and the proposed S&P 500 index options on C2 (i.e., a.m. vs. 
p.m. settlement) is a ``sham'' that is intended to ``keep them non-
fungible,'' which would ``make a mockery of Section 11A of the Act.'' 
\19\ The commenter states that the objectives of Section 11A are 
reflected in a national market system plan for options that requires 
exchanges to prevent trading through better priced quotations displayed 
on other options exchanges, and that making a p.m.-settled S&P 500 
index option non-fungible with CBOE's SPX would allow the CBOE group to 
establish two ``monopolies'' in S&P 500 options, one floor-based (CBOE) 
and one electronic (C2) that would avoid the application of the 
limitation on trade throughs.\20\ The commenter also contends the 
proposal is designed to protect CBOE's floor-based SPX trading without 
having to accommodate the more narrow quotes that would likely occur on 
C2 in an electronically-traded p.m.-settled product.\21\
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    \18\ See ISE Letter 1, supra note 4, at 4.
    \19\ Id. at 2. See also ISE Letter 2, supra note 4, at 3-4.
    \20\ See ISE Letter 1, supra note 4, at 3.
    \21\ See ISE Letter 1, supra note 4, at 2.
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    Another commenter asserts that CBOE and C2 should trade a fungible 
S&P 500 index option in order to address what the commenter describes 
as ``huge customer-unfriendly spreads'' in SPX.\22\ The commenter 
argues that if the CBOE believes p.m. settlement is superior to a.m. 
settlement, then CBOE should file to change SPX to p.m. settlement so 
that the product traded on C2 would be fungible with that proposed to 
be traded on CBOE.\23\
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    \22\ See Trader Letter, supra note 4, at 1. See also JP Letter, 
supra note 4, at 1.
    \23\ See Trader Letter, supra note 4, at 1.
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    In response, C2 argues that the difference between a.m.-settled and 
p.m.-settled S&P 500 index option would be a material term and that 
C2's proposed S&P 500 index option could not be fungible with, nor 
could it be linked with, CBOE's SPX option.\24\
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    \24\ See C2 Response Letter, supra note 5, at 3.
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    The Commission agrees that the difference between a.m.-settled SPX 
and the proposed p.m.-settled SPXPM involves a materially different 
term (i.e., settlement time) that makes C2's proposed SPXPM index 
option a different security than, and thus not fungible with, CBOE's 
SPX option.\25\ The Commission notes that it has permitted very similar 
but different products to trade on the same exchange or on different 
exchanges without those separate products being fungible. For example, 
the Commission previously approved for CBOE the listing and trading of 
a.m.-settled S&P 500 index options during a time when CBOE also traded 
p.m.-settled S&P 500 index options, and the two separate products were 
not fungible.\26\
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    \25\ Consequently, rules applicable to prevent trading through 
better priced quotations in the same security displayed on other 
options exchanges would not be applicable for trading between these 
two products.
    Similarly, in response to a comment that investors would be 
confused by the presence of an a.m.-settled SPX on CBOE and a p.m.-
settled S&P 500 index option on C2 (see ISE Letter 1, supra note 4, 
at 3), the Commission does not believe that SPX on CBOE and a p.m.-
settled S&P 500 index option on C2 would cause investor confusion. 
The two products would trade under different ticker symbols and any 
potential for investor confusion could be mitigated though investor 
outreach and education initiatives. Furthermore, as C2 notes in its 
response letter, CBOE currently lists two options on the S&P 100 
(American-style OEX and European-style XEO) and is not aware of any 
investor confusion among the products. See C2 Response Letter, supra 
note 5, at 3.
    \26\ See infra note 44 (citing to Securities Exchange Act 
Release No. 24367). See also Securities Exchange Act Release No. 
51619 (Apr. 27, 2005), 70 FR 22947 (May 3, 2005) (order approving 
ISE's listing and trading of options on various Russell Indexes, 
including options based upon one-tenth values of the Russell 
Indexes).

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[[Page 55971]]

    One commenter also raises concerns about the potential effect on 
competition of C2 listing and trading an option product that is subject 
to an exclusive license, citing to concerns they express with respect 
to the SPX product traded on CBOE.\27\
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    \27\ See ISE Letter 1, supra note 4, at 6-7 (arguing in part 
that ``CBOE's monopoly in the product imposes significant harm to 
investors,'' including the fact that ``CBOE charges for trading SPX 
options that are much greater than the fees for multiply listed 
options'' and ``the quotes in SPX options are much wider than they 
would be if there was competition from other exchanges,'' as well as 
that ``CBOE is able to use the monopolistic revenue stream from 
these options to subsidize other products * * *.'') and ISE Letter 
2, supra note 4, at 3-4 (arguing in part that ``[t]he Proposal is 
harmful to investors because it * * * perpetuates the unreasonably 
high monopolistic pricing and artificially wide spreads that result 
from the lack of competition in this product.'').
    The issue of state law intellectual property rights of index 
developers in the use of their indexes to trade derivatives is the 
subject of litigation between CBOE and ISE (as well as other 
parties). See Chicago Board Options Exchange, Incorporated et al. v. 
International Securities Exchange, et al., Case No. 06 CH 24798 
(Cir. Ct. of Cook Cty., Ch. Div. July 8, 2010), appeal docketed, No. 
1-10-2228 (Ill. App. Ct. August 9, 2010). See also Board of Trade of 
the City of Chicago v. Dow Jones & Co., Inc., 98 Ill.2d 109 (1983). 
In issuing this order, the Commission expresses no view with respect 
to the matters underlying this ongoing litigation, including their 
validity or the enforceability of the exclusivity agreement.
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    The Commission recognizes the potential impact on competition 
resulting from the inability of other options exchanges to list and 
trade SPXPM. In acting on this proposal, however, the Commission has 
balanced the potentially negative competitive effects with the 
countervailing positive competitive effects of C2's proposal. The 
Commission believes that the availability of SPXPM on the C2 exchange 
will enhance competition by providing investors with an additional 
investment vehicle, in a fully-electronic trading environment, through 
which investors can gain and hedge exposure to the S&P 500 stocks. 
Further, this product could offer a competitive alternative to other 
existing investment products that seek to allow investors to gain broad 
market exposure. Also, we note that it is possible for other exchanges 
to develop or license the use of a new or different index to compete 
with the S&P 500 index and seek Commission approval to list and trade 
options on such index.
    Accordingly, with respect to the Commission's consideration of C2's 
proposed rule change at this time, the Commission finds that it does 
not impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Act.\28\
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    \28\ The Commission may in the future determine it appropriate 
to consider or address competitive issues related to exclusive 
licensing of index option products on a more comprehensive level.
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B. Position Limits

    Under C2's proposal, position limits would not apply to SPXPM. One 
commenter argues that position limits should apply to SPXPM.\29\ This 
commenter notes that, since 2001 when the Commission approved a CBOE 
rule filing to remove all position limits for SPX options,\30\ the 
Commission has generally expected exchanges to apply a model, such as 
the Dutt-Harris model, to determine the appropriate position limits for 
all new index options products.\31\ Because C2 claims that the product 
is new and non-fungible, the commenter argues that the Commission 
should apply the Dutt-Harris model to require C2 to impose position 
limits on SPXPM.\32\
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    \29\ See ISE Letter 1, supra note 4, at 6.
    \30\ See Securities Exchange Act Release No. 44994 (October 26, 
2002), 66 FR 55722 (November 2, 2001). In this filing, the 
Commission relied in part on CBOE's ability to provide enhanced 
surveillance and reporting safeguards to detect and deter trading 
abuses arising from the elimination of position and exercise limits 
in options on the S&P 500.
    \31\ See ISE Letter 1, supra note 4, at 6. In a 2005 paper from 
Hans Dutt and Lawrence Harris, titled ``Position Limits for Cash-
Settled Derivative Contracts'' (``Dutt-Harris Paper'') the authors 
developed a model to determine appropriate position limits for cash-
settled index derivatives. The authors concluded that the then-
prevailing position limits were lower than the model suggested would 
be appropriate for many derivative contracts. The authors also 
concluded, however, that position limits are not as important for 
broad-based index derivative contracts that are cash settled because 
they are composed of highly liquid and well-followed securities. As 
such, the authors note that it would require very high trading 
volumes to manipulate the underlying securities and, consequently, 
any attempted manipulation would be more easily detectable and 
prosecutable.
    \32\ See ISE Letter 1, supra note 4, at 6.
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    In its response to comments, C2 notes that the Dutt-Harris Paper 
acknowledges that S&P 500 options have, and should have, 
extraordinarily large position limits and Dutt-Harris observes that 
position limits are most useful when market surveillance is 
inadequate.\33\ C2 argues that position limits suggested by the Dutt-
Harris model for an S&P 500 index option would be so large as to be 
irrelevant and that positions of such magnitude would attract scrutiny 
from surveillance systems that would, as a consequence, serve as an 
effective substitute for position limits.\34\ Further, in its response 
letter, C2 summarizes the circumstances and considerations relied upon 
by the Commission when it approved the elimination of position limits 
on CBOE's S&P 500 index option, including the enormous capitalization 
of the index and enhanced reporting and surveillance for the 
product.\35\ Thus, because of the enhanced reporting and surveillance 
for this product, described below, C2 argues that the absence of 
position limits on its proposed S&P 500 index option would not be 
inconsistent with Dutt-Harris.\36\
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    \33\ See C2 Response Letter, supra note 5, at 5.
    \34\ See id. Generally, position limits are intended to prevent 
the establishment of options positions that could be used or that 
might create incentives to manipulate or disrupt the underlying 
market to benefit the holder of the options. See, e.g., Securities 
Exchange Act Release Nos. 39489 (December 24, 1997), 63 FR 276 
(January 5, 1998) (SR-CBOE-97-11) (approving increases to the 
position and exercise limits for options on the Standard & Poor's 
100 Stock Index (``OEX''), the OEX firm facilitation exemption, and 
the OEX index hedge exemption); Dutt-Harris Paper, supra note 31 
(``Position limits directly limit manipulation by limiting the size 
of derivative positions that would benefit from manipulative 
practices.'').
    \35\ See C2 Response Letter, supra note 5, at 5-6. C2 represents 
in its response letter that it would monitor trading in p.m.-settled 
S&P 500 index options in the same manner as CBOE does for other 
broad-based index options with no position limits. See id. at 6.
    \36\ See id.
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    The Exchange represents, however, that it will implement enhanced 
reporting requirements pursuant to its Rule 4.13 (Reports Related to 
Position Limits) and Interpretation and Policy .03 to its Rule 24.4 
(Position Limits for Broad-Based Index Options), which sets forth the 
reporting requirements for certain broad-based indexes that do not have 
position limits.\37\
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    \37\ See Notice, supra note 3, at note 4 and accompanying text.
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    In 2001, when the Commission permanently approved a CBOE rule 
(which had been in place for a two-year pilot period) to eliminate 
position limits on SPX (as well as options on the Dow Jones Industrial 
Average and the S&P 100 index),\38\ the Commission stated that because 
the S&P 500 index is a broad-based index with a considerable 
capitalization, manipulation of the 500 component stocks underlying the 
index would require extraordinarily large positions that would be 
readily detectable by enhanced surveillance procedures. In its approval 
order, the Commission relied in part on CBOE's enhanced surveillance 
and reporting procedures that are intended to allow CBOE to detect and 
deter trading abuses in the absence of position limits. In particular, 
CBOE requires its members to submit a report to CBOE when the member 
builds a position of 100,000+ contracts. Among other things, the report 
includes a description of the

[[Page 55972]]

option position, whether the position is hedged (and, if so, a 
description of the hedge), and whether collateral was used (and, if so, 
a description of the collateral). This enhanced surveillance and 
reporting arrangement allows CBOE to continually monitor, assess, and 
respond to any concerns at an early stage. To complement its enhanced 
surveillance and reporting requirements, CBOE has the ability to 
intervene to impose additional margin or assess capital charges when 
warranted. Thus, together with the ``enormous capitalization'' \39\ of 
the S&P 500 index and the deep and liquid markets for the S&P 500 
stocks, the Commission found that CBOE's enhanced surveillance 
procedures ``reduce[] concerns regarding market manipulation or 
disruption in the underlying market.'' \40\
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    \38\ See Securities Exchange Act Release No. 44994 (October 26, 
2001), 66 FR 55722 (November 2, 2001) (SR-CBOE-2001-22).
    \39\ Id. at 55723.
    \40\ Id.
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    C2 has represented in this filing that its enhanced surveillance 
requirements and procedures for SPXPM would be identical to the 
surveillance and reporting requirements and procedures used by CBOE 
with respect to SPX. Accordingly, the Commission believes that position 
limits would not be necessary for SPXPM options as long as C2 has in 
place and enforces effective enhanced surveillance and reporting 
requirements. These enhanced procedures will allow the Exchange to see, 
with considerable advance notice, the accumulation of large positions, 
which it can then monitor more closely as necessary and take additional 
action if appropriate.\41\
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    \41\ In addition, the Commission notes that C2 would have access 
to information through its membership in the Intermarket 
Surveillance Group with respect to the trading of the securities 
underlying the S&P 500 index, as well as tools such as large options 
positions reports to assist its surveillance of SPXPM options.
    In approving the proposed rule change, the Commission also has 
relied upon the Exchange's representation that it has the necessary 
systems capacity to support new options series that will result from 
this proposal. See Notice, supra note 3, at 12777.
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C. Reintroduction of P.M. Settlement

    When cash-settled \42\ index options were first introduced in the 
1980s, they generally utilized closing-price settlement procedures 
(i.e., p.m. settlement).\43\ The Commission became concerned about the 
impact of p.m. settlement on cash-settled index options on the markets 
for the underlying stocks at the close on expiration Fridays.\44\ These 
concerns were heightened during the quarterly expirations of the third 
Friday of March, June, September and December when options, index 
futures, and options on index futures all expire simultaneously. P.m.-
settlement was believed to have contributed to above-average volume and 
added market volatility on those days, which sometimes led to sharp 
price movements during the last hour of trading.\45\ As a consequence, 
the close of trading on the quarterly expiration Friday became known as 
the ``triple witching hour.'' Besides contributing to investor anxiety, 
heightened volatility during the expiration periods created the 
opportunity for manipulation and other abusive trading practices in 
anticipation of the liquidity constraints.\46\
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    \42\ The seller of a ``cash settled'' index option pays out the 
cash value of the applicable index on expiration or exercise. A 
``physically settled'' option, like equity and ETF options, involves 
the transfer of the underlying asset rather than cash. See 
Characteristics and Risks of Standardized Options, available at: 
http://www.theocc.com/components/docs/riskstoc.pdf, for a discussion 
of settlement.
    \43\ The exercise settlement value for a p.m.-settled index 
option is generally determined by reference to the reported level of 
the index as derived from the closing prices of the component 
securities (generally based on the closing prices as reported by the 
primary exchange on which the stock is listed) on the last business 
day before expiration (e.g., the Friday before Saturday expiration). 
See Characteristics and Risks of Standardized Options, available at: 
http://www.theocc.com/components/docs/riskstoc.pdf, for a discussion 
of settlement value.
    \44\ See, e.g., Securities Exchange Act Release Nos. 45956 (May 
17, 2002), 67 FR 36740 (May 24, 2002) (adopting release concerning 
cash settlement and regulatory halt requirements for security 
futures products) (``Regulators and self-regulators were concerned 
that the liquidity constraints faced by the securities markets to 
accommodate expiration-related buy or sell programs at the market 
close on expiration Fridays could exacerbate ongoing market swings 
during an expiration and could provide opportunities for entities to 
anticipate these pressures and enter orders as part of manipulative 
or abusive trading practices designed to artificially drive up or 
down share prices.''); 24367 (April 17, 1987), 52 FR 13890 (April 
27, 1987) (SR-CBOE-87-11) (order approving a proposal for S&P 500 
index options with an exercise settlement value based on an index 
value derived from opening, rather than closing, prices); and 32868 
(September 10, 1993), 58 FR 48687 (September 10, 1993) (notice of 
filing and order granting accelerated approval of proposed rule 
change by the New York Stock Exchange, Inc. (``NYSE'') relating to 
changes in auxiliary closing procedures for expiration days) 
(stating, ``[a]s long as some index derivative products continue to 
expire based on closing stock prices on expiration Fridays, the 
Commission agrees with the NYSE that such procedures are necessary 
to provide a mechanism to handle the potential large imbalances that 
can be engendered by firms unwinding index derivative related 
positions''). The cash settlement provisions of stock index futures 
and options contracts facilitated the growth of sizeable index 
arbitrage activities by firms and professional traders and made it 
relatively easy for arbitrageurs to buy or sell the underlying 
stocks at or near the market close on expiration Fridays (i.e., the 
third Friday of the expiration month) in order to ``unwind'' 
arbitrage-related positions. These types of unwinding programs at 
the close on expiration Fridays often severely strained the 
liquidity of the securities markets as the markets, and in 
particular the specialists on the NYSE, faced pressure to attract 
contra-side interest in the limited time that was permitted to 
establish closing prices. See Securities Exchange Act Release No. 
44743 (August 24, 2001), 66 FR 45904 (August 30, 2001) (File No. S7-
15-01) (proposing release concerning cash settlement and regulatory 
halt requirements for security futures products).
    \45\ See, e.g., Securities Exchange Act Release Nos. 24276 
(March 27, 1987); 52 FR 10836 (April 3, 1987) (notice of filing and 
order granting accelerated approval to a proposed rule change by the 
NYSE relating to opening price settlement of expiring NYSE Composite 
and Beta Index options); 37894 (October 30, 1996), 61 FR 56987 
(November 5, 1996) (notice of filing and order granting accelerated 
approval of proposed rule change by the NYSE permanently approving 
the expiration day auxiliary closing procedures pilot program); and 
45956 (May 17, 2002), 67 FR 36740 (May 24, 2002) (adopting release 
concerning cash settlement and regulatory halt requirements for 
security futures products) (reaffirming the Commission's view of the 
advantages of a.m. settlement). See also Hans Stoll and Robert 
Whaley, Expiration Day Effects of Index Options & Futures (March 15, 
1986) (noting that share volume on the NYSE was much higher in the 
last hour of a quarterly expiration Friday when both options and 
futures expire than on non-expiration Fridays).
    \46\ See, e.g., Securities Exchange Act Release No. 45956 (May 
17, 2002), 67 FR 36740 (May 24, 2002) (adopting release concerning 
cash settlement and regulatory halt requirements for security 
futures products) (explaining that entities could take advantage of 
illiquidity resulting from the unwinding of arbitrage-related 
positions on expiration Fridays to manipulate share prices).
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    In light of the concerns with p.m. settlement and to help 
ameliorate the price effects associated with expirations of p.m.-
settled, cash-settled index products, in 1987, the Commodity Futures 
Trading Commission (``CFTC'') approved a rule change by the Chicago 
Mercantile Exchange to provide for a.m. settlement for index futures, 
including futures on the S&P 500 index.\47\ The Commission subsequently 
approved a rule change by CBOE to list and trade a.m.-settled S&P 500 
index options.\48\ In

[[Page 55973]]

1992, the Commission approved CBOE's proposal to transition all of its 
European-style cash-settled options on the S&P 500 index to a.m. 
settlement.\49\ Thereafter, the Commission approved proposals by the 
options markets to transfer most of their cash-settled index products 
to a.m. settlement.\50\
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    \47\ See Proposed Amendments Relating to the Standard and Poor's 
500, the Standard and Poor's 100 and the Standard Poor's OTC Stock 
Price Index Futures Contract, 51 FR 47053 (December 30, 1986) 
(notice of proposed rule change from the Chicago Mercantile 
Exchange). See also Securities Exchange Act Release No. 24367 (April 
17, 1987), 52 FR 13890 (April 27, 1987) (SR-CBOE-87-11) (noting that 
the Chicago Mercantile Exchange moved the S&P 500 futures contract's 
settlement value to opening prices on the delivery date).
    The exercise settlement value for an a.m.-settled index option 
is determined by reference to the reported level of the index as 
derived from the opening prices of the component securities on the 
business day before expiration.
    \48\ See Securities Exchange Act Release No. 24367 (April 17, 
1987), 52 FR 13890 (April 27, 1987) (SR-CBOE-87-11) (order approving 
a proposal for S&P 500 index options with an exercise settlement 
value based on an index value derived from opening, rather than 
closing, prices). At the time it approved CBOE's introduction of 
a.m. settlement for cash-settled index options, the Commission 
identified two benefits to a.m. settlement for cash-settled index 
options. See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992) (SR-CBOE-92-09). First, it 
provides additional time to test price discovery, as market 
participants have the remainder of the regular trading day to adjust 
to opening session price movements and determine whether those 
movements reflect changes in fundamental values or short-term supply 
and demand conditions. Second, it provides more opportunity to trade 
out of positions acquired during the opening auction. In this 
respect, attracting contra-side interest to a single-priced auction 
to offset an order imbalance (such as those attributable to index 
arbitrage) may more readily be achieved in an opening auction on 
Friday morning than a closing auction on Friday afternoon because 
the morning session allows market participants that have provided 
that liquidity to have the remainder of the regular trading day to 
liquidate their positions. In contrast, positions acquired in a 
Friday afternoon closing auction generally cannot be liquidated as 
readily and efficiently until the following Monday. Holding 
positions overnight, or over a weekend, may entail greater risk than 
holding intraday positions. To accept such risk (real or perceived), 
market participants generally will require a greater premium, which 
may translate into greater price concessions, and thus lead to 
greater volatility in the closing auction. In other words, a 
consequence of p.m. settlement may be enhanced volatility at the 
close. See, e.g., Securities Exchange Act Release No. 44743 (August 
24, 2001), 66 FR 45904 at 45908 (August 30, 2001) (``Steep discounts 
(premiums) were necessary in part because traders who bought (sold) 
stocks to offset unwinding programs had to maintain their newly 
acquired long (short) positions over the weekend--during which time 
they were subject to considerable market risk.'').
    \49\ See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992) (SR-CBOE-92-09) (order approving 
CBOE's proposal relating to position limits for SPX index options 
based on the opening price of component securities).
    \50\ CBOE's index options on the S&P 100 (OEX), however, kept 
their p.m. settlement. See Securities Exchange Act Release No. 30944 
(July 21, 1992), 57 FR 33376 (July 28, 1992) (SR-CBOE-92-09). No 
futures or options on futures trade on the S&P 100 index. Other 
types of options utilize p.m. settlement, including physically-
settled single-stock options and options on ETFs.
---------------------------------------------------------------------------

    The Commission and the CFTC noted the benefits of a.m. settlement 
in a 2001 joint release concerning securities futures, where they 
observed that ``the widespread adoption of opening-price settlement 
procedures in index futures and options has served to mitigate the 
liquidity strains that had previously been experienced in the 
securities markets on expirations.'' \51\
---------------------------------------------------------------------------

    \51\ See Securities Exchange Act Release No. 44743 (August 24, 
2001), 66 FR 45904 at 45908 (August 30, 2001) (proposing release for 
a joint rule between the Commission and the CFTC generally 
stipulating, among other provisions, that the final settlement price 
for each cash-settled security futures product fairly reflect the 
opening price of the underlying security or securities). See also 
Securities Exchange Act Release No. 45956 (May 17, 2002), 67 FR 
36740 at 36741-42 (May 24, 2002) (adopting release concerning cash 
settlement and regulatory halt requirements for security futures 
products in which the Commission reaffirmed the advantages of a.m. 
settlement) (``[O]pening price settlement procedures offered several 
features that enabled the securities markets to better handle 
expiration-related unwinding programs.'').
---------------------------------------------------------------------------

    Since 1992, the Commission has approved proposals that provide for 
cash-settled index options with p.m. settlement on a limited basis for 
options products that generally are characterized by lower relative 
volume and that generally do not involve settlement on the third Friday 
of a month.\52\ At the time of each approval, the Commission stated 
that limited approvals on a pilot basis would allow the exchange and 
the Commission to monitor the potential for adverse market effects and 
modify or terminate the pilots, if necessary. Notably, with the 
exception of FLEX Index options, these recently-approved p.m.-settled 
contracts do not involve expiration on the third Friday of the month. 
These new contracts, including FLEX, have also been characterized by 
limited volume, and would not be expected to have a pronounced effect 
on volatility in the underlying securities at the close as a result.
---------------------------------------------------------------------------

    \52\ In particular, in 1993, the Commission approved CBOE's 
proposal to list and trade p.m.-settled, cash-settled options on 
certain broad-based indexes expiring on the first business day of 
the month following the end of each calendar quarter (``Quarterly 
Index Expirations''). See Securities Exchange Act Release No. 31800 
(February 1, 1993), 58 FR 7274 (February 5, 1993) (SR-CBOE-92-13). 
In 2006, the Commission approved, on a pilot basis, CBOE's listing 
of p.m.-settled index options expiring on the last business day of a 
calendar quarter (``Quarterly Options Series''). See Securities 
Exchange Act Release No. 54123 (July 11, 2006), 71 FR 40558 (July 
17, 2006) (SR-CBOE-2006-65). In January 2010, the Commission 
approved CBOE's listing of p.m.-settled FLEX options on a pilot 
basis.\52\ See Securities Exchange Act Release No. 61439 (January 
28, 2010), 75 FR 5831 (February 4, 2010) (SR-CBOE-2009-087) (order 
approving rule change to establish a pilot program to modify FLEX 
option exercise settlement values and minimum value sizes). FLEX 
options provide investors with the ability to customize basic option 
features including size, expiration date, exercise style, and 
certain exercise prices. Prior to 2010, only a.m. settlement based 
on opening prices of the underlying components of an index could be 
used to settle a FLEX index option if it expired on, or within two 
business days of, a third-Friday-of-the-month expiration (``Blackout 
Period''). Last year, the Commission approved a pilot program to 
permit FLEX index options with p.m. settlement that expire within 
the Blackout Period. See Securities Exchange Act Release No. 61439 
(January 28, 2010), 75 FR 5831 (February 4, 2010) (SR-CBOE-2009-
087). In September 2010, the Commission approved CBOE's listing of 
p.m.-settled End of Week expirations (expiring on each Friday, other 
than the third Friday) and End of Month expirations (expiring on the 
last trading day of the month) for options on broad-based indexes, 
also on a pilot basis. See Securities Exchange Act Release No. 62911 
(September 14, 2010), 75 FR 57539 (September 21, 2010) (SR-CBOE-
2009-075).
---------------------------------------------------------------------------

    In response to C2's proposal, two commenters raise concerns over 
the reintroduction of p.m. settlement on a potentially popular index 
derivative and the possible impact that doing so could have on the 
underlying cash equities markets.\53\ One commenter urges the 
Commission to consider why markets went to a.m. settlement in the early 
1990s and opines that hindsight supports the conclusion that a.m. 
settlement has been good for the markets.\54\ While acknowledging that 
the answer is not clear, the commenter asks the Commission to consider 
whether it is now safe to return to the dominance of p.m.-settled index 
options and futures.\55\ However, this commenter submitted a subsequent 
letter in which he agreed with the Exchange that ``conditions today are 
vastly different'' from those that drove the transition to a.m. 
settlement.\56\ The commenter concludes that C2's proposal should be 
approved on a pilot basis, which would allow the Commission to collect 
data to closely analyze the impact of the proposal.\57\
---------------------------------------------------------------------------

    \53\ See ISE Letter 1, supra note 4, at 4-5; ISE Letter 2, supra 
note 4, at 2-3; and Mayne Letter 1, supra note 4, at 1-2.
    \54\ See Mayne Letter 1, supra note 4, at 1 (noting that 
concerns with p.m. settlement ``led to the advent of the far more 
innocuous, and perhaps more fair `AM-Print' method of determining 
the final value for expiring index options. To judge by the 
abatement of the negative press, hindsight would seem to support 
that the AM-Print made for a more level playing field.'')
    \55\ See id. at 2.
    \56\ See Mayne Letter 2, supra note 4, at 1.
    \57\ See id.
---------------------------------------------------------------------------

    A different commenter describes the history behind the transition 
to a.m. settlement and criticizes C2 for trivializing that history.\58\ 
This commenter argues that a mainstream return to the ``discredited'' 
p.m. settlement would ``risk undermining the operation of fair and 
orderly financial markets.'' \59\ The commenter notes that experience 
with the ``flash crash'' of May 6, 2010 demonstrates that the current 
market structure struggles to find price equilibriums, and that 
dispersed trading is a ``mirage'' as participants often flock to the 
same liquidity centers in time of stress.\60\ In its July comment 
letter, the commenter took a slightly different approach by arguing 
that fragmentation is the biggest change to the markets since 1987 when 
markets moved to a.m. settlement.\61\ The commenter notes that even 
with almost all volume concentrated on one exchange back in the 1980s, 
the markets could not address closing liquidity and volatility concerns 
and prevent market disruptions on ``triple witch'' settlement

[[Page 55974]]

dates.\62\ The commenter believes that fragmentation makes it almost 
impossible for any single market to concentrate liquidity at the close 
to produce an effective clearing price at times of market 
volatility.\63\ In addition, the commenter argues that exchange-
specific closing procedures are only applicable to trading on one 
exchange, which represents a small fraction of the overall market 
today, and therefore will have little ability to dampen market 
volatility.\64\ The commenter believes that C2's proposal would 
exacerbate liquidity strains by reintroducing an extraordinary market 
event--the triple witching hour--and argues that allowing S&P 500 index 
options to be based on closing settlement prices, even on a pilot 
basis, would re-introduce the potential for extreme market volatility 
at expiration.\65\
---------------------------------------------------------------------------

    \58\ See ISE Letter 1, supra note 4, at 4.
    \59\ Id.
    \60\ See id.
    \61\ See ISE Letter 3, supra note 8, at 2.
    \62\ See id.
    \63\ See id.
    \64\ See id.
    \65\ See ISE Letter 1, supra note 4, at 5. This commenter also 
notes that recently-imposed circuit breakers in the cash equities 
markets do not apply in the final 25 minutes of trading. See id.
---------------------------------------------------------------------------

    In addition, the commenter states that Commission approval of C2's 
proposal would lead to the reintroduction of multiple p.m.-settled 
derivatives and argues that while the SPXPM pilot would be troubling, 
having multiple pilots operating simultaneously would undermine the 
industry-wide move to a.m. settlement.\66\ The Commission generally 
considers relevant information available to it at the time it reviews 
each filing in evaluating whether the filing is consistent with the 
Act.\67\
---------------------------------------------------------------------------

    \66\ See ISE Letter 3, supra note 8, at 3.
    \67\ See 15 U.S.C. 78s(b) (concerning Commission consideration 
of proposed rule changes submitted by self-regulatory 
organizations).
---------------------------------------------------------------------------

    Taking the opposite view, two commenters urge the Commission to 
approve the proposal on a pilot basis.\68\ One commenter asserts its 
belief that C2's proposal will not cause greater volatility in the 
underlying securities of the S&P 500 index.\69\ This commenter opines 
that whether an options contract is p.m.-settled as opposed to a.m.-
settled is not a contributing factor to volatility, and the commenter 
notes that there is more liquidity in the securities underlying the S&P 
500 index at the close compared to the opening.\70\ The commenter 
states that exchanges are well equipped to handle end-of-day volume and 
that existing p.m.-settled products do not contribute to increased 
volatility.\71\ The other commenter states that the reintroduction of 
p.m. settlement is long overdue and would attract liquidity from dark 
pools, crossing mechanisms, and the over-the-counter markets.\72\
---------------------------------------------------------------------------

    \68\ See IMC Letter, supra note 4, at 1-2 and JP Letter, supra 
note 4.
    \69\ See IMC Letter, supra note 4, at 1.
    \70\ See id.
    \71\ See id. at 2.
    \72\ See JP Letter, supra note 4.
---------------------------------------------------------------------------

    In its initial response to comments, C2 argues that the concerns 
from 18 years ago that led to the transition to a.m. settlement for 
index derivatives have been largely mitigated.\73\ C2 argues that 
expiration pressure in the underlying cash markets at the close has 
been greatly reduced with the advent of multiple primary listing and 
unlisted trading privilege markets, and that trading is now widely 
dispersed among many market centers.\74\ C2 further argues that opening 
procedures in the 1990s were deemed acceptable to mitigate one-sided 
order flow driven by index option expiration and that today's more 
sophisticated automated closing procedures should afford a similar, if 
not greater, level of comfort.\75\ Specifically, C2 notes that many 
markets, notably The NASDAQ Stock Market LLC (``Nasdaq'') and the NYSE, 
now utilize automated closing cross procedures and have closing order 
types that facilitate orderly closings, and that these closing 
procedures are well-equipped to mitigate imbalance pressure at the 
close.\76\ In addition, C2 believes that after-hours trading now 
provides market participants with an alternative to help offset market-
on-close imbalances.\77\
---------------------------------------------------------------------------

    \73\ See C2 Response Letter, supra note 5, at 4.
    \74\ See id.
    \75\ See C2 Response Letter, supra note 5, at 4.
    \76\ See id.
    \77\ See id. at 2.
---------------------------------------------------------------------------

    C2 also notes that for roughly five years (1987-1992) CBOE listed 
both a.m.- and p.m.-settled SPX and did not observe any related market 
disruptions during that period in connection with the dual a.m./p.m. 
settlement.\78\ Finally, C2 believes that p.m.-settled options 
predominate in the over-the-counter (``OTC'') market, and C2 is not 
aware of any adverse effects in the underlying cash markets 
attributable to the considerable volume of OTC trading.\79\ C2 asserts 
that given the changes since the 1980s, concerns with p.m. settlement 
are ``misplaced'' and have been ``negated'' now that closing procedures 
on the cash equities markets have become more automated with real-time 
data feeds that are distributed to a wider array of market 
participants.\80\
---------------------------------------------------------------------------

    \78\ See Notice, supra note 3, at 12776.
    \79\ See id.
    \80\ See C2 Response Letter, supra note 5, at 2 and 4. In its 
comment letter, ISE notes that C2's claim that electronic trading 
can smooth out the price-setting process is ``disingenuous'' as 
recent history suggests that the opposite may be true in some cases 
(such as the market events of May 6, 2010). See ISE Letter 1, supra 
note 4, at 5.
---------------------------------------------------------------------------

    The Commission agrees with C2 that the closing cross mechanisms on 
the primary listing stock markets have matured considerably since the 
late 1980s. Closing procedures used by the primary equity markets now 
offer a more transparent and automated process for attracting contra-
side interest and determining closing prices in a manner that is 
comparable to the process used to determine opening prices.\81\ The 
Commission recognizes, however, that the ability of such procedures to 
counter-balance any potential negative effects that could stem from 
p.m. settlement is dependent on their ability to attract liquidity in a 
fragmented market to the primary listing exchanges during a very 
concentrated window of time at the close of trading on expiration 
Fridays. Consequently, the potential effect that p.m.-settlement of 
cash-settled index options could have on the underlying cash equities 
markets at expiration remains unclear and the Commission remains 
concerned about

[[Page 55975]]

the possible effect on volatility at the close of a return to p.m. 
settlement for cash-settled index options.\82\
---------------------------------------------------------------------------

    \81\ Nasdaq (see Nasdaq Rule 4754), NYSE (see NYSE Rule 123C), 
and NYSE Amex LLC (``NYSE Amex'') (see NYSE Amex Rule 123C) all have 
automated closing cross procedures for their equities markets, which 
are designed to attract liquidity, to determine a price for a 
security that minimizes any imbalance, and to match orders at the 
4:00 p.m. close. Participants of these exchanges generally receive 
frequently-disseminated market data reports reflecting any 
imbalance, which is intended to attract offsetting interest to 
minimize or eliminate an imbalance heading into the close. NYSE 
Arca, Inc. has closing procedures (NYSE Arca Rule 7.35), but it only 
conducts a closing cross for securities in which it is the primary 
listing market as well as for all exchange-listed derivatives.
    Additionally, to minimize the potential for price swings at the 
close, Nasdaq provides that the closing price must be within an 
acceptable range of 10% of the midpoint of the NBBO, while the NYSE 
permits the Designated Market Maker in a stock to request that the 
exchange extend its trading day to not longer than 4:30 p.m. to 
allow for the solicitation and entry of orders that are specifically 
solicited to offset an imbalance existing as of 4 p.m. To further 
minimize selling pressure at the NYSE, market-on-close and limit-on-
close orders may be entered after 3:45 p.m. only if they offset an 
imbalance. The NYSE also provides for closing-only orders that only 
execute if they offset an imbalance. The Commission views these 
closing cross procedures as a significant change in how orders are 
handled at the close of trading that could potentially help reduce 
volatility at the close caused by p.m. settlement.
    C2 also notes that SPXPM expiration dates would be predetermined 
and known in advance and, as a consequence, this awareness could 
facilitate the generation of contra-side trading interest. See C2 
Response Letter, supra note 5, at 3. The potential for reoccurring 
heightened volatility during these expiration periods may, however, 
increase the opportunity for manipulation and other abusive trading 
practices in anticipation of the liquidity constraints. To the 
extent such volatility was possible, active surveillance and robust 
enforcement activity by C2 and other self-regulatory organizations 
around expiration dates would help to address the potential for 
abusive trading.
    \82\ The Commission's concern with the potential effect that 
p.m.-settlement of cash-settled index options could have on the 
underlying cash equities markets at expiration takes into 
consideration, as C2 notes, that the use of closing prices by retail 
and institutions investors is widespread. See C2 Letter 3, supra 
note 8, at 6. For example, mutual funds use closing prices to 
calculate their net asset values. Therefore, any event or product 
that potentially introduces additional volatility into the process 
of determining closing prices has the potential to harm investors 
and the public interest.
---------------------------------------------------------------------------

    C2 cites to the Commission's recent approval of a series of 
proposals that authorized the expansion of a limited subset of options 
products to p.m. settlement along with data collected in connection 
with those products as revealing no evidence that p.m. settlement is 
likely to have a disruptive effect on volatility at the close.\83\ We 
do not believe that such an inference necessarily can be drawn. These 
prior approvals involved sub-categories of options that are generally 
characterized by relatively low volume and thus would not be expected 
to have a pronounced effect on volatility in the underlying securities 
at the close on expiration.\84\ Further, many of these products are not 
authorized for listing with expiration on the third Friday of a month 
when other cash-settled index derivatives expire. For example, C2 
mentions CBOE's experience with End-of-Week p.m.-settled options (which 
it notes is the most heavily traded of CBOE's new special-dated 
expiration products), and concludes that they fail to show any evidence 
of disruptive volatility on the settlement days for these 
contracts.\85\ Despite the fact that End-of-Week p.m.-settled options 
constitute over 7% of CBOE's S&P 500 index option volume, their volume 
does not compare to that of CBOE's SPX product, which accounts for 60% 
of all index options trading. For this reason, it is difficult to draw 
any conclusions about the potential impact of p.m.-settled S&P 500 
index options on the market for the underlying component stocks based 
on the existing p.m.-settled cash-settled options. Further, past 
experience suggests that the potential impact would be more significant 
if both index options and index futures (and options on index futures) 
were offered with p.m. settlement.
---------------------------------------------------------------------------

    \83\ See C2 Letter 3, supra note 8, at 4-5.
    \84\ We note that historical experience with respect to more 
heavily traded index options and index futures indicates that p.m. 
settlement carries additional risks for enhanced volatility on 
settlement days. See, e.g., Hans Stoll and Robert Whaley, Expiration 
Day Effects of Index Options & Futures (March 15, 1986) (concluding 
that price effects ``are observable on quarterly futures expirations 
* * * [and] [t]he volatility of prices is significantly higher on 
such expiration days, and the stock market indices tend to fall on 
such expiration days.'').
    \85\ See id. at 5.
---------------------------------------------------------------------------

    While the enhanced closing processes on the primary listing markets 
may serve to mitigate some of the risk that imbalances on the 
underlying cash markets prior to the close could lead to excess 
volatility, the extent of that mitigation is unclear. A pilot program 
would provide an opportunity to observe and analyze the actual effects 
on the underlying cash markets of SPXPM. Further, to the extent that 
trading interest is redirected to the primary markets during times of 
stress, as one commenter noted, it could be conducive to addressing an 
imbalance to concentrate liquidity on the primary markets during the 
close. In particular, those markets conduct automated closing cross 
procedures, described above,\86\ that are designed to more efficiently 
disseminate information broadly and attract and offset imbalances. We 
note, however, that despite C2's emphasis on the higher volumes in 
today's markets compared with the 1980s and the dispersion of trading 
to more venues,\87\ volume statistics are not necessarily indicative or 
predictive of the level of available liquidity.\88\
---------------------------------------------------------------------------

    \86\ See supra note 81.
    \87\ See id.
    \88\ See, e.g., Findings Regarding the Market Events of May 6, 
2010, Report of the Staffs of the CFTC and SEC to the Joint Advisory 
Committee on Emerging Regulatory Issues, available at http://www.sec.gov/news/studies/2010/marketevents-report.pdf, at page 6 
(``As the events of May 6 demonstrate, especially in times of 
significant volatility, high trading volume is not necessarily a 
reliable indicator of market liquidity.'').
---------------------------------------------------------------------------

    Finally, C2 estimates that 95% of OTC options based on the S&P 500 
index are p.m.-settled,\89\ and states that SPXPM will attract some of 
that trading interest. C2 notes that doing so would be consistent with 
the objectives of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act and could help mitigate counterparty risks faced by OTC 
market participants.\90\ The Commission agrees that the proposal could 
benefit investors to the extent it attracts trading in p.m.-settled S&P 
500 index options from the opaque OTC market to the more transparent 
exchange-listed markets.
---------------------------------------------------------------------------

    \89\ See C2 Letter 3, supra note 8, at 13.
    \90\ See id.
---------------------------------------------------------------------------

    Further, C2's proposal will offer investors another investment 
option through which they could obtain and hedge exposure to the S&P 
500 stocks. In addition, C2's proposal will provide investors with the 
ability to trade an option on the S&P 500 index in an all-electronic 
market, which may better meet the needs of investors who may prefer to 
trade electronically.\91\ Accordingly, C2's proposal will provide 
investors with added flexibility through an additional product that may 
be better tailored to meet their particular investment, hedging, and 
trading needs.
---------------------------------------------------------------------------

    \91\ See, e.g., Exchange Capital Resources Letter, supra note 8, 
at 3 (stating in part that ``* * * the addition of the SPXPM product 
will offer the investor greater flexibility and opportunity to 
participate in S&P 500 option product line.'')
---------------------------------------------------------------------------

    To assist the Commission in assessing any potential impact of a 
p.m.-settled S&P 500 index option on the options markets as well as the 
underlying cash equities markets, as discussed above,\92\ C2 has 
proposed to submit data to the Commission on a confidential basis in 
connection with the pilot. The Commission believes that C2's proposed 
fourteen-month pilot, together with the data and analysis that C2 will 
provide to the Commission, will allow C2 and the Commission to monitor 
for and assess the potential for adverse market effects. Specifically, 
the data and analysis will assist the Commission in evaluating the 
effect of allowing p.m. settlement for S&P 500 index options on the 
underlying component stocks.
---------------------------------------------------------------------------

    \92\ See Section II (Description of the Proposal).
---------------------------------------------------------------------------

    In light of the fact that approval of C2's proposal would be a 
change from a.m. settlement for cash-settled index options, the 
Commission instituted proceedings to determine whether to approve or 
disapprove the proposal. In particular, through specific requests for 
comment and data, the Commission solicited input from market 
participants on the potential impact on the markets, particularly the 
underlying cash equities markets.
    As discussed above, the Commission remains concerned about the 
potential impact on the market at expiration for the underlying 
component stocks for a p.m.-settled, cash-settled index option such as 
SPXPM. The potential impact today remains unclear, given the 
significant changes in the closing procedures of the primary markets 
over the past two decades. The Commission is mindful of the historical 
experience with the impact of p.m. settlement of cash-settled index 
derivatives on the underlying cash markets, discussed at length above, 
but recognizes, however, that these risks may be mitigated today by the 
enhanced closing procedures that are now in use at the primary equity 
markets.
    Finally, approval of C2's proposal on a pilot basis will enable the 
Commission to collect current data to assess and monitor for any 
potential for impact on markets, including the underlying cash

[[Page 55976]]

equities markets. In particular, the data collected from C2's pilot 
program will help inform the Commission's consideration of whether the 
SPXPM pilot should be modified, discontinued, extended, or permanently 
approved. It also could benefit investors and the public interest to 
the extent it attracts trading in p.m.-settled S&P 500 index options 
from the opaque OTC market to the more transparent exchange-listed 
markets, where trading in the product will be subject to exchange 
trading rules and exchange surveillance.
    Thus, based on the discussion above, the Commission finds that C2's 
current proposal is consistent with the Act, including Section 6(b)(5) 
thereof in that it is designed to remove impediments to and perfect the 
mechanism of a free and open market, and, in general, to protect 
investors and the public interest. In light of the enhanced closing 
procedures and the potential benefits to investors discussed above, the 
Commission finds that it is appropriate and consistent with the Act to 
approve C2's proposal on a pilot basis. The collection of data during 
the pilot and C2's active monitoring of any effects of SPXPM on the 
markets will help the Commission assess the impact of p.m. settlement 
in today's market.

V. Conclusion

    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\93\ that the proposed rule change (SR-C2-2011-008) be, and hereby 
is, approved on a 14-month pilot basis only.
---------------------------------------------------------------------------

    \93\ 15 U.S.C. 78s(b)(2).

    By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-23045 Filed 9-8-11; 8:45 am]
BILLING CODE 8011-01-P


