
[Federal Register Volume 76, Number 202 (Wednesday, October 19, 2011)]
[Notices]
[Pages 64980-64983]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-26990]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-65548; File No. SR-ISE-2011-39]


Self-Regulatory Organizations; International Securities Exchange, 
LLC; Order Approving a Proposed Rule Change Relating to Complex Orders

October 13, 2011.

I. Introduction

    On July 1, 2011, the International Securities Exchange, LLC (the 
``Exchange'' or the ``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 amend ISE Rule 722, ``Complex 
Orders.'' The proposed rule change was published for comment in the 
Federal Register on July 15, 2011.\3\ The Commission received one 
comment letter regarding the proposed rule change and \4\ ISE submitted 
a response to the comment letter.\5\ This order approves 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. 64853 (July 11, 
2011), 76 FR 41850 (``Notice'').
    \4\ See letter to Elizabeth M. Murphy, Secretary, Commission, 
from Geva Patz, Principal, Android Alpha Fund, dated July 27, 2011 
(``Android Letter'').
    \5\ See letter to Elizabeth M. Murphy, Secretary, Commission, 
from Michael J. Simon, Secretary and General Counsel, ISE, dated 
October 12, 2011 (``ISE Letter'').
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II. Description

    The ISE proposes to amend ISE Rule 722 to: (1) Allow market makers 
to enter quotations for complex order strategies on the complex order 
book, provide that such quotations will not execute automatically 
against bids and offers for the individual legs of the order, and make 
existing market maker risk management tools available for these 
quotations; (2) add a size pro rata method of execution priority for 
bids and offers on the complex order book at the same price; and (3) 
provide for an enhanced allocation of complex orders to a market maker 
that an Electronic Access Member (``EAM'') designates as a ``Preferred 
Market Maker'' and that satisfies certain requirements.

A. Quotations for Complex Orders

    Currently, ISE market makers may enter quotes for single-leg 
options orders, but not for complex order strategies.\6\ New 
Supplementary Material .03 to ISE Rule 722 allows market makers to 
enter quotes for complex order strategies on the complex order book in 
their appointed options classes and provides that these quotes will not 
execute automatically against bids and offers for the individual legs 
of the order.\7\ Market makers will continue to have the ability to 
enter complex orders on the complex order book. ISE represents that it 
is not aware of any demand from non-market maker

[[Page 64981]]

participants to quote on the complex order book.\8\
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    \6\ Only market makers may enter quotes. See ISE Rule 804(a) 
(stating that a quotation only may be entered by a market maker, and 
only in the options classes to which the market maker is appointed 
under ISE Rule 802). See also ISE Rule 100(a)(42) (defining 
``quote'' or ``quotation'' as a bid or offer entered by a market 
maker that updates the market maker's previous bid or offer, if 
any).
    \7\ Quotes and orders are processed as they are received by the 
ISE's trading system. Quotes are not processed more quickly than 
orders. See Notice at footnote 5.
    \8\ See Notice, 76 FR at 41852.
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    New Supplementary Material .03 to ISE Rule 722 provides that 
complex order quotes may not be marked for price improvement,\9\ nor 
are market makers required to enter quotes for complex orders. 
Quotations and executions against complex orders shall not be taken 
into consideration in determining whether a market maker is meeting, 
respectively, its quoting obligations under ISE Rule 804 or its 
obligation under ISE Rule 805 to refrain from executing more than a 
specified percentage of contracts in options classes which it is not 
appointed.\10\ Under new Supplementary Material .04 to ISE Rule 722, 
the same risk management tools that currently are available for market 
maker quotes in the individual leg market will also be available for 
market makers' complex order quotes.\11\
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    \9\ In contrast, under ISE Rule 722(b)(3)(iii), complex orders 
may be marked for price improvement and exposed for up to one second 
before executing automatically against pre-existing complex orders 
or bids and offers for the individual legs.
    \10\ Telephone conversation among Kathy Simmons, Deputy General 
Counsel, ISE, and David Hsu, Assistant Director, Division of Trading 
and Markets (``Division''), Commission, and Yvonne Fraticelli, 
Special Counsel, Division, Commission, on October 12, 2011. A 
Primary Market Maker must, on a daily basis, enter continuous 
quotations and enter into any resulting transactions in all of the 
series listed on ISE of the options classes to which the market 
maker is appointed. A Competitive Market Maker must, on a given day, 
participate in the opening rotation and make markets and enter into 
any resulting transactions on a continuous basis in at least 60% of 
the series listed on ISE of at least 60% of the options classes for 
the Group to which the Competitive Market Maker is appointed or 40 
options classes in the Group, whichever is lesser. See ISE Rule 
804(e)(1) and (2). The total number of contracts executed during a 
quarter by a Competitive Market Maker in options classes in which it 
is not appointed may not exceed 25% of the total number of contracts 
traded by such Competitive Market Maker in classes to which it is 
appointed and with respect to which it was quoting pursuant to ISE 
Rule 804(e)(2). The total number of contracts executed during a 
quarter by a Primary Market Maker in options classes to which it is 
not appointed may not exceed 10% of the total number of contracts 
traded per each Primary Market Maker Membership. See ISE Rule 
805(b)(2) and (3).
    \11\ ISE Rule 804, Supplementary Material .01 sets forth certain 
enhanced risk management tools that currently are available for 
market maker quotes in the individual leg market. See Securities 
Exchange Act Release No. 63117 (October 15, 2010), 75 FR 65042 
(October 21, 2010) (notice of filing and immediate effectiveness of 
File No. SR-ISE-2010-101).
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B. Size Pro Rata Execution Priority

    Currently, ISE may designate on a class basis whether complex 
orders at the same price on the complex order book will execute (A) in 
time priority; or (B) on a size pro-rata basis after all Priority 
Customer Orders at the same price have been executed in full.\12\ As 
amended, ISE Rule 722(b)(3)(i) adds a third method of execution 
priority that will allow ISE to designate on a class basis that bids 
and offers on the complex order book at the same price may be executed 
pro-rata based on size. Under this priority method, Priority Customer 
Orders would receive a pro-rata allocation along with all other orders 
and quotes at the same price.\13\
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    \12\ See ISE Rule 722(b)(3)(i).
    \13\ ISE notes that the new execution priority provision does 
not affect ISE Rule 722(b)(2), which, among other things, provides 
requirements for executing complex orders when the established bid 
or offer on ISE for any leg of the complex order consists of a 
Priority Customer Order. See Notice, 76 FR at 41851.
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C. Enhanced Allocation for Complex Orders

    New Supplementary Material .05 to ISE Rule 722 provides an enhanced 
allocation for a market maker quoting at the best price that is 
designated by the entering EAM as a Preferred Market Maker. The 
enhanced allocation will be available only for options classes that are 
allocated pro-rata based on size with Priority Customer Order priority, 
and a Preferred Market Maker that satisfies the requirements of 
Supplementary Material .05 will receive an enhanced allocation only 
after all Priority Customer Orders on the complex order book at the 
same price have been executed in full.\14\ A Preferred Market Maker on 
the complex order book must satisfy its quoting obligations in the 
options class in the regular leg market, including the enhanced quoting 
requirements in ISE Rule 804(e)(2)(ii) applicable to Competitive Market 
Makers that receive Preferenced Orders.\15\ Accordingly, a market maker 
must be quoting at least 90% of the series of an options class in the 
regular market to receive an enhanced allocation on the complex order 
book.
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    \14\ See ISE Rule 722, Supplementary Material .05.
    \15\ See ISE Rule 722, Supplementary Material .05. Among other 
things, ISE Rule 804(e)(2)(ii) requires a Competitive Market Maker 
to maintain continuous quotations in at least 90% of the series of 
any options class in which it receives Preferenced Orders.
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    After all Priority Customer Orders on the complex order book at the 
same price have been executed in full, a Preferred Market Maker that 
satisfies the requirements in ISE Rule 722, Supplementary Material .05 
will receive an allocation equal to the greater of: (i) The proportion 
of the total size at the best price represented by the size of the 
market maker's quote; or (ii) 60% of the contracts to be allocated if 
there is only one other Professional Order or market maker quotation at 
the best price, and 40% of the contracts to be allocated if there are 
two or more other Professional Orders and/or market maker quotes at the 
best price.\16\
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    \16\ See ISE Rule 722, Supplementary Material .05.
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III. Discussion and Commission's 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.\17\ In particular, the Commission finds that the proposed 
rule change is consistent with Section 6(b)(5) of the Act,\18\ 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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    \17\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 78c(f).
    \18\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that allowing market makers to enter 
quotations for complex order strategies, as well as complex orders, in 
the complex order book is consistent with the Act. Allowing market 
markers to submit complex order quotes could result in additional 
liquidity for complex orders on ISE, thereby potentially benefitting 
investors.\19\
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    \19\ See ISE Rule 722, Supplementary Material .03.
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    The Commission also believes that the limitation on automatic 
executions of market maker complex order strategy quotations against 
leg market interest is consistent with the Act. According to the ISE, 
this limitation is designed to address an operational issue that ISE 
believes could discourage market makers from adding liquidity to the 
complex order book. This operational issue may arise when a market 
maker updating its complex order strategy quotation inadvertently 
trades with its own leg market quotations or the leg market quotations 
of another market maker before the complex order strategy quotation 
update is processed. By addressing an operational issue that might 
discourage market makers from adding liquidity to the complex order 
book, the Commission believes that the limitation on automatic 
executions against leg market interest could help to increase liquidity 
in the complex order

[[Page 64982]]

book, thus benefitting investors seeking to execute complex orders.
    The Commission believes that the market maker risk management tools 
in new Supplementary Material .04 to ISE Rule 722 could assist ISE 
market makers in effectively managing their complex order strategy 
quotations. Accordingly, the Commission believes that Supplementary 
Material .04 to ISE Rule 722 is consistent with the Act.
    The proposal also amends ISE Rule 722(b)(3)(i) to provide for 
executions of complex orders at the same price on a size pro-rata 
basis.\20\ The Commission believes that providing an additional method 
of execution priority in ISE Rule 722(b)(3)(i) will provide ISE with 
greater flexibility in determining how complex order bids and offers at 
the same price may be executed. The Commission notes that the rules of 
other options exchanges currently permit size pro-rata executions of 
orders at the same price.\21\ In addition, the Commission notes that 
the addition of this new execution priority method to ISE Rule 
722(b)(3)(i) does not affect the complex order priority provisions in 
ISE Rule 722(b)(2).\22\
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    \20\ See ISE Rule 722(b)(3)(i)(C).
    \21\ See, e.g., CBOE Rule 6.45B(a)(i) and C2 Rule 6.12(a)(2). In 
approving CBOE direct, a screen-based trading system, the Commission 
stated that both price-time priority and pro rata priority were 
consistent with the Act. See Securities Exchange Act Release No. 
47628 (April 3, 2003), 68 FR 17697 (April 10, 2003) (order approving 
File No. SR-CBOE-00-55).
    \22\ See Notice, 76 FR at 41851. ISE Rule 722(b)(2) provides 
that a complex order may be executed at a total net debit or credit 
price with one other Member without giving priority to bids or 
offers established in the marketplace that are no better than the 
bids or offers comprising such total credit or debit, provided that 
if any of the bids or offers in the marketplace consists of a 
Priority Customer Order, the price of at least one leg of the 
complex order must trade at a price that is better than the 
corresponding bid or offer in the marketplace by at least one 
minimum trading increment, as defined in ISE Rule 710.
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    The Commission believes that new Supplementary Material .05 to ISE 
Rule 722, which permits preferencing of certain complex orders to a 
market maker with a quote at the best price on the complex order book 
that the EAM entering the order designates as a ``Preferred Market 
Maker,'' is consistent with the Act. The Commission notes that the 
Chicago Board Options Exchange, Inc. (``CBOE'') currently permits 
preferencing of complex orders \23\ and that the requirements for 
receiving an enhanced complex order allocation under ISE Rule 722, 
Supplementary Material .05, are the same as the requirements for 
receiving an enhanced complex order allocation under CBOE Rule 8.13, 
Commentary .01. Although the ISE and CBOE rules provide different 
complex order percentage allocations for Preferred Market Makers, the 
complex order percentage allocation in ISE Rule 722, Supplementary 
Material .05 is the same as the enhanced allocation for single options 
currently provided to Preferred Market Makers under ISE Rule 713, 
Supplementary Material .03(c), which the Commission previously 
approved.\24\ The Commission also notes ISE's statement that it would 
be a violation of ISE Rule 400, ``Just and Equitable Principles of 
Trade,'' for EAMs and Preferred Market Makers to coordinate their 
action, and ISE's representation that it will proactively conduct 
surveillance for, and enforce against, such violations.\25\ For 
example, it would be a violation of ISE Rule 400 for an EAM to notify a 
Preferred Market Maker immediately prior to sending a complex order so 
that the market maker could post a complex order strategy quotation on 
the complex order book before the EAM's order arrived.
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    \23\ See CBOE Rule 8.13, Interpretation and Policy .01. See also 
Securities Exchange Act Release No. 60957 (November 6, 2009), 74 FR 
58332 (November 12, 2009) (File No. SR-CBOE-2009-070) (approving 
proposal to establish a participation entitlement for complex 
orders).
    \24\ See Securities Exchange Act Release No. 51818 (June 10, 
2005), 70 FR 35146 (June 16, 2005) (order approving File No. SR-ISE-
2005-18). Under CBOE's rules, the complex order participation 
entitlement for a Preferred Market Maker, after equivalent net 
priced orders in the EBook and equivalent public customer orders 
resting in the complex order book have been satisfied, is 40% when 
there are two or more market makers quoting at the best net priced 
bid/offer execution price, and 50% when there is only one other 
market maker quoting at the best net priced bid/offer execution 
price. See CBOE Rule 8.13, Interpretation and Policy .01(b). Under 
ISE Rules 713, Supplementary Material .03(c) and 722, Supplementary 
Material .05, a Preferred Market Maker has a participation right 
equal to: (i) the proportion of the total size at the best price 
represented by the size of its quote; or (ii) 60% of the contracts 
to be allocated if there is only one other Professional Order or 
market maker quotation at the best price and 40% if there are two or 
more other Professional Orders and/or market maker quotes at the 
best price.
    \25\ See Notice at footnote 10. See also Securities Exchange Act 
Release No. 51818 (June 10, 2005), 70 FR 35146 (June 16, 2005) 
(order approving File No. SR-ISE-2005-18) at footnote 10.
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    The Commission received one comment letter regarding the proposed 
rule change.\26\ ISE responded to the commenter letter.\27\ The 
commenter expresses concern that ISE lacks the system capacity to 
handle the additional volume that market maker complex order quotes 
could produce.\28\ In particular, the commenter notes that ISE's 
systems incur overhead to create a new instrument whenever a complex 
order is created for a new spread, regardless of whether any trades 
occur in that spread.\29\ According to the commenter, ISE had indicated 
that this overhead could become problematic even at the level of a few 
tens of thousands of spreads.\30\ Noting that there are over 24,000,000 
valid two-legged spreads alone for options currently traded on ISE, the 
commenter believed that ISE's system would be unable to keep up with 
the volume of quotations even if ISE market makers chose to quote only 
a small fraction of these spreads.\31\ Accordingly, the commenter 
believes that the proposal ``presents a serious risk of causing an 
unacceptable degradation of exchange infrastructure to the detriment of 
all users, both current and potential, of the ISE Complex Order Book,'' 
and urged the Commission not approve the proposal ``unless and until 
the ISE is able to provide adequate assurances that its systems will 
not be adversely affected by the change.'' \32\
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    \26\ See Android Letter, supra note 4.
    \27\ See ISE Letter, supra note 5.
    \28\ See Android Letter, supra note 4, at 1.
    \29\ See Android Letter, supra note 4, at 1.
    \30\ See id.
    \31\ See id.
    \32\ Android Letter, supra note 4, at 2.
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    In its response to the commenter's concerns regarding the number of 
complex order strategies that potentially could trade on ISE, ISE 
states that the Exchange currently supports 3,000 complex order 
instruments per options class, for a total of more than 7.2 million 
instruments on a daily basis.\33\ ISE states, further, that far fewer 
than 3,000 complex order instruments have ever traded across all 
options class on ISE on a single day.\34\ Accordingly, ISE believes 
that it has more than sufficient capacity to meet investor demand.\35\
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    \33\ See ISE Letter, supra note 5, at 1.
    \34\ See id.
    \35\ See id.
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    In response to the commenter's concern regarding the potential 
increase in quotation volume, ISE states that it maintains a rigorous 
capacity planning program that monitors system performance and 
projected capacity demands, and that, as a general matter, ISE 
considers the potential system capacity impact of all new 
initiatives.\36\ ISE represents that it has analyzed the potential for 
additional message traffic resulting from market makers entering quotes 
on the complex order book and has concluded that, while quotes may 
update more frequently than orders, it has sufficient system capacity 
to handle those quotes without degrading the performance of its systems 
or reducing the number of complex order instruments it currently 
supports.\37\ In addition, ISE states that because market

[[Page 64983]]

makers are able to update multiple instruments with a single quote 
change, encouraging market makers to add liquidity to the complex order 
book through quotations, rather than orders, will require less ISE 
capacity.\38\ For example, ISE notes that ISE market makers currently 
must enter two separate orders to update a bid and an offer for each 
complex order instrument.\39\ However, market makers will be able to 
update both the bid and the offer for multiple complex order 
instruments with one quote change.\40\
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    \36\ See id.
    \37\ See ISE Letter, supra note 5, at 1-2.
    \38\ See ISE Letter, supra note 5, at 2.
    \39\ See id.
    \40\ See id.
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    In approving the proposed rule change, the Commission has relied on 
ISE's representation that it has the necessary systems capacity to 
implement the proposed changes. The Commission expects ISE to continue 
to monitor the quoting volume associated with market makers' complex 
order strategy quotations and its effect on ISE's systems.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\41\ that the proposed rule change (SR-ISE-2011-39) is approved.
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    \41\ 15 U.S.C. 78s(b)(2).
    \42\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\42\
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-26990 Filed 10-18-11; 8:45 am]
BILLING CODE 8011-01-P


