
[Federal Register Volume 78, Number 52 (Monday, March 18, 2013)]
[Notices]
[Pages 16726-16729]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-06087]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-69110; File No. SR-ISE-2013-22]


Self-Regulatory Organizations; International Securities Exchange, 
LLC; Notice of Filing of Proposed Rule Change To Suspend Certain Market 
Maker Quotation Requirements and To Suspend Rule 720 Regarding Obvious 
Errors During Limit Up-Limit Down States in Securities That Underlie 
Options Traded on the ISE

March 11, 2013.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\, and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on March 8, 2013, the International Securities Exchange, LLC 
(``ISE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') the proposed rule change as 
described in Items I, II, and II below, which Items have been prepared 
by the Exchange. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to suspend certain market maker quotation 
requirements and to suspend Rule 720 regarding obvious errors during 
limit up-limit down states in securities that underlie options traded 
on the ISE on a pilot basis. The text of the proposed rule

[[Page 16727]]

change is available on the Exchange's Web site www.ise.com, at the 
principal office of the Exchange, and at the Commission's Public 
Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The self-regulatory organization has prepared summaries, 
set forth in Sections A, B and C below, of the most significant aspects 
of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and the 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    On May 31, 2012, the Commission approved the Plan to Address 
Extraordinary Market Volatility (the ``Plan''),\3\ which establishes 
procedures to address extraordinary volatility in NMS Stocks. The 
procedures provide for market-wide limit up-limit down requirements 
that prevent trades in individual NMS Stocks from occurring outside of 
specified Price Bands. These limit up-limit down requirements are 
coupled with Trading Pauses to accommodate more fundamental price 
moves. The Plan procedures are designed, among other things, to protect 
investors and promote fair and orderly market.\4\
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    \3\ Securities Exchange Act Release No. 67091 (May 31, 2012), 77 
F.R. 33498 (June 6, 2012) (File No. 4-631) (``Plan Approval 
Order'').
    \4\ Id. at 33511 (Preamble to the Plan).
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    ISE is not a participant in the Plan because it does not trade NMS 
Stocks. However, the ISE trades options contracts overlying NMS Stocks. 
Because options pricing models are highly dependent on the price of the 
underlying security and the ability of options traders to effect 
hedging transactions in the underlying security, the implementation of 
the Plan will impact the trading of options classes traded on the 
Exchange. Specifically, under the Plan, upper and lower price bands 
will be calculated based on a reference price for each NMS Stock.\5\ 
When one side of the market for an individual security is outside the 
applicable price band, the national best bid or national best offer 
will be disseminated with a flag identifying it as non-executable 
(i.e., a ``Straddle State''). When the other side of the market reaches 
the applicable price band, such national best bid or offer will be 
disseminated with a flag identifying it as a Limit State Quotation.\6\ 
If trading for a security does not exit a Limit State within 15 
seconds, a Trading Pause will be declared by the Primary Listing 
Exchange.\7\ The Trading Pause will last at least five minutes\8\ and 
will end when the Primary Listing Exchange disseminates a Reopening 
Price.\9\
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    \5\ The reference price equals the arithmetic mean price of 
eligible reported transactions for the NMS Stock over the 
immediately preceding five-minute period. See Section I(T) of the 
Plan.
    \6\ See Section I(D) of the Plan. The Limit State will end when 
the entire size of all Limit State Quotations are executed or 
cancelled.
    \7\ See Section VII(A) of the Plan. The Primary Listing Exchange 
is the market on which an NMS Stock is listed. If an NMS Stock is 
listed on more than one market, the Primary Listing Exchange is the 
market on which the security has been listed the longest. See 
Section I(O) of the Plan. A trading pause may also be declared when 
the national best bid (offer) is below (above) the lower (upper) 
price band and the security is not in a Limit State, and trading in 
that security deviates from normal trading characteristics. See 
Section VII(A)(2) of the Plan.
    \8\ A Trading Pause may last longer than 5 minutes if, for 
example, the Primary Market declares a Regulatory Halt, or if there 
is a significant order imbalance. See Section VII(B) of the Plan. If 
the Primary Listing Exchange does not report a Reopening Price 
within ten minutes after the declaration of a trading Pause and has 
not declared a Regulatory Halt, all trading centers may begin 
trading the security. Id.
    \9\ The Reopening Price is the price of a transaction that 
reopens trading on the Primary Listing Exchange following a Trading 
Pause or a Regulatory Halt, or, if the Primary Listing Exchange 
reopens with quotations, the midpoint of those quotations. The 
Exchange notes that under ISE Rule 702(c), trading on the Exchange 
is halted whenever trading in the underlying security has been 
paused by the primary listing market. Accordingly, the Exchange need 
not adopt any rule changes to address this aspect of the Plan.
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    When the national best bid (offer) for a security underlying an 
options class is non-executable, the ability for options market 
participants purchase (sell) shares of the underlying security and the 
price at which they may be able to purchase (sell) shares will become 
uncertain, as there will be a lack of transparency regarding the 
availability of liquidity for the security.\10\ This uncertainty will 
be factored into the options pricing models of market professionals, 
such as options market makers, which will likely result in wider 
spreads and less liquidity at the best bid and offer for the options 
class. Accordingly, during a Limit State, the Exchange will 
automatically reject all incoming orders that do not contain a limit 
price to protect them from being executed at prices that may be vastly 
inferior to the prices available immediately prior to or following a 
Limit State or Straddle State.\11\ Such un-priced orders include market 
orders and stop orders, which become market orders when the stop price 
is elected. The Exchange will also cancel any unexecuted market orders 
and unexecuted stop orders.
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    \10\ See Letter to Boris Ilyevsky, Managing Director, ISE, from 
Thomas Price, Managing Director, Securities Industry and Financial 
Markets Association, dated October 4, 2012 (``SIFMA Letter''). A 
copy of the letter is provided in Exhibit 2 to the filing.
    \11\ See SR-ISE-2013-20 (filed March 4, 2013).
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    In light of the unusual market conditions, the Exchange proposes to 
suspend the maximum quotation spread requirement for market maker 
quotes contained in Rule 803(b)(5) and the continuous market maker 
quotation requirements contained in Rule 804(e) when the security 
underlying an option class is in a Limit State or Straddle State. The 
Exchange believes it may be very difficult for market makers to price 
options classes when there is uncertainty as to whether they are unable 
to buy and sell the underlying security, or at what prices and in what 
quantity. While some market makers may choose to provide liquidity in 
such circumstances, the risk associated with doing so may be too great 
for others.\12\ The Exchange proposes to remove maximum spread 
requirements to encourage market makers to choose to provide liquidity 
during Limit States and Straddle States, as market makers will be 
discouraged from entering any quotations if they must do so within the 
maximum spread requirement.
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    \12\ The time periods associated with Limit States and Straddle 
States will not be considered by the Exchange when evaluating 
whether a market maker complied with the continuous quotation 
requirements contained in Rule 804(e).
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    The Exchange also proposes to exclude transactions executed during 
a Limit State or Straddle State from the provision of ISE Rule 720, on 
a one-year pilot basis. Rule 720 provides a process by which a 
transaction may be busted or adjusted when the execution price of a 
transaction deviates from the option's theoretical price by a certain 
amount. Under Rule 720, the theoretical price is the national best bid 
price for the option with respect to a sell order and the national best 
offer for the option with respect to a buy order.\13\ As discussed

[[Page 16728]]

above, during a Limit State or Straddle State, options prices may 
deviate substantially from those available prior to or following the 
limit state. The Exchange believes this provision would give rise to 
much uncertainty for market participants as there is no bright line 
definition of what the ``theoretical value'' should be for an option 
when the underlying NMS stock has an unexecutable bid or offer or both. 
Determining ``theoretical value'' in such a situation would be often 
times very subjective as opposed to an objective determination giving 
rise to additional uncertainty and confusion for investors. 
Accordingly, the Exchange does not believe that the approach employed 
under Rule 720, which by definition depends on a reliable national best 
bid and offer in the option, is appropriate during a Limit State or 
Straddle State.\14\
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    \13\ Rule 720 provides that if there are no quotes from other 
options exchanges for comparison purposes, the theoretical price 
will be determined by designated personnel in the Exchange's market 
control center. However, given that options market makers and other 
industry professionals will have difficulty pricing options during 
Limit States and Straddle States, the Exchange does not believe it 
would be reasonable for ISE personnel to derive theoretical prices 
to be applied to transactions executed during such unusual market 
conditions.
    \14\ See SIFMA Letter, supra note 10 (requesting that exchange 
obvious error rules that reference theoretical prices be reviewed to 
ensure that options exchange officials do not have the discretion to 
cancel executions of limit orders and stop limit orders during a 
limit or straddle state).
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    After careful consideration, the Exchange believes the application 
of the current rule would be impracticable given the lack of a reliable 
national best bid or offer in the options market during Limit States 
and Straddle States, and produce undesirable effects. Pursuant to Rule 
720, market participants have five minutes (in the case of a market 
maker) and 20 minutes (in the case of an Electronic Access Member) to 
notify the Exchange to review a transaction as an obvious error under 
720(c) and market participants have until 8:30 a.m. the following day 
to request that the Exchange review a trade as a catastrophic error 
under Rule 720(d).\15\ The Exchange believes that during periods of 
extraordinary volatility, the review period for transactions under the 
obvious error and catastrophic error provisions would allow market 
participants to re-evaluate a transaction that occurred during a Limit 
State or Straddle State at a later time, which is potentially unfair to 
other market participants and would discourage market participants from 
providing liquidity during Limit States or Straddle States. For 
example, 20 minutes after a transaction that occurs during 
extraordinary volatility that triggers a Limit State or Straddle State 
the market could look drastically different from a price and liquidity 
level The Exchange believes that market participants should not be able 
to benefit from the time frame to review their transactions in these 
situations. Suspending application of Rule 720 would mitigate two of 
the undesirable aspects described above--(i) the moral hazard 
associated with granting a second look to trades that went against the 
market participant after market conditions have changed and (ii) gaming 
the obvious error rule to retroactively adjust market maker quotes by 
adjusting the execution price at a later time.
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    \15\ For transactions in expiring options series that take place 
on expiration Friday, the Member must notify the Exchange by 5:00 
p.m. Eastern Time on that same day. See Rule 720(d)(1).
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    The Exchange notes that there are additional protections in place 
outside of the Obvious and Catastrophic Error Rule that will continue 
to safeguard customers. First, SEC Rule 15c3-5 requires that, 
``financial risk management controls and supervisory procedures must be 
reasonably designed to prevent the entry of orders that exceed 
appropriate pre-set credit or capital thresholds, or that appear to be 
erroneous.'' \16\ Secondly, the Exchange has price checks applicable to 
limit orders that rejects limit orders that are priced sufficiently far 
through the NBBO that it seems likely an error occurred. The 
requirements placed upon broker dealers to adopt controls to prevent 
the entry of orders that appear to be erroneous, coupled with Exchange 
functionality that filters out orders that appear to be erroneous serve 
to sharply reduce the incidence of errors arising from situations, for 
example, where a participant mistakenly enters an order to pay $20 for 
an option offered at $2. The Exchange also notes that pursuant to ISE 
Rule 705(d), the Exchange may compensate Members for losses resulting 
directly from the malfunction of the Exchange's systems, and that this 
protection is independent from ISE Rule 720. Accordingly, the Exchange 
believes it is appropriate to eliminate any potential protection 
applying the obvious error rule might provide during Limit and Straddle 
States, as its application may produce inequitable results.
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    \16\ See Securities and Exchange Act Release No. 63241, 75 FR 
69791 (November 15, 2010) (S7-03-10).
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    The Exchange proposes to review the operation of this provision 
during the one-year pilot period for the proposal and analyze the 
impact of the Limit and Straddle States accordingly.\17\ In this 
respect, the Exchange notes that its current obvious error rule does 
not contain a provision that permits the Exchange to review trades on 
its own motion. The Exchange believes that in normal market conditions, 
such a provision is not necessary and undermines the objective nature 
of the rule. However, during the pilot period, the Exchange will 
evaluate whether adopting such a provision for review trades during 
Limit and Straddle states is necessary and appropriate.
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    \17\ During the pilot, the Exchange will provide the commission 
with data regarding the how Limit and Straddle States effect the 
quality of the options market.
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    The Exchange notes that these proposed changes are consistent with 
the views of the Securities Industry and Financial Markets 
Association's (``SIFMA'') Listed Options Trading Committee.\18\
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    \18\ Id.
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2. Statutory Basis
    The Exchange believes that its proposal is consistent with Section 
6(b) of the Securities Exchange Act of 1934 (the ``Act'') \19\ in 
general, and furthers the objectives of Section 6(b)(5) of the Act \20\ 
in particular, in that it is designed to promote just and equitable 
principles of trade, to remove impediments to and perfect the mechanism 
for a free and open market and a national market system, and, in 
general, to protect investors and the public interest.
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    \19\ 15 U.S.C. 78f(b).
    \20\ 15 U.S.C. 78f(b)(5).
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    In consideration of the substantial risk associated with market 
making during such unusual market conditions, the Exchange believes 
exempting market makers from their continuous quotation obligations 
during Limit States and Straddle States, and removing maximum spread 
requirements for market makers quotes during such states, is necessary 
and appropriate to promote just and equitable principles of trade. As 
stated above, it may be very difficult for market makers to price 
options classes when there is uncertainty as to whether they will be 
able to buy and sell the underlying security, or at what prices and in 
what quantity. Moreover, giving options market makers the flexibility 
to choose whether to enter quotes and to do so without spread 
restrictions is necessary to encourage market makers to provide 
liquidity in options classes overlying securities that may enter a 
Limit State or Straddle State. The Exchange believes that encouraging 
liquidity in such options classes will help to assure a more fair and 
orderly market for investors leading up to, during, and following Limit 
States and Straddle States.
    All other requirements related to market maker quotes will be 
applicable to market makers that choose to enter quotes during a Limit 
State or Straddle State. In this respect, the Exchange notes that such 
market makers continue to be subject to many obligations,

[[Page 16729]]

including the obligation to maintain a fair and orderly market in their 
appointed classes, and that market makers are not permitted to make 
bids or offers or enter into transactions that are inconsistent with 
such course of dealings. Given that market makers are subject to these 
additional obligations when entering quotes, the Exchange believes it 
is appropriate to apply its normal execution principles if market 
makers choose to enter quotes during Limit States or Straddle States, 
even if they are not under an obligation to provide liquidity during 
these brief periods. The Exchange also notes that it would be 
impractical to apply a different execution algorithm during such brief 
and infrequent unusual market conditions, and that in any such case, 
the Exchange believes that removing incentives for market makers to 
provide liquidity during Limit States or Straddle States would serve to 
decrease the quality of its markets during these brief and unusual 
market conditions. For these reasons, the Exchange believes that the 
balance between the benefits provided to market makers and the 
obligations imposed upon market makers during Limit States and Straddle 
States by the proposed rule change is appropriate
    The Exchange further believes that it is necessary and appropriate 
in the interest of promoting fair and orderly markets to exclude 
transactions executed during a Limit State or Straddle State from the 
provision of ISE Rule 720. The Exchange believes the application of the 
current rule will be impracticable given the lack of a relievable 
national best bid or offer in the options market during Limit States 
and Straddle States, and that the resulting actions (i.e., busted 
trades or adjusted prices) may not be appropriate given market 
conditions. This change would ensure that limit orders that are filled 
during a Limit State or Straddle State would have certainty of 
execution in a manner that promotes just and equitable principles of 
trade, removes impediments to, and perfects the mechanism of a free and 
open market and a national market system. Moreover, given that options 
prices during brief Limit States or Straddle States may deviate 
substantially from those available shortly following the Limit State or 
Straddle State, the Exchange believes giving market participants five 
minutes (in the case of a market maker) and 20 minutes (in the case of 
an Electronic Access Member) to re-evaluate a transaction would create 
an unreasonable adverse selection opportunity that would discourage 
participants from providing liquidity during Limit States or Straddle 
States. In this respect, the Exchange notes that by rejecting market 
orders and stop orders, and cancelling pending market orders and stop 
orders, only those orders with a limit price will be executed during a 
Limit State or Straddle State. Therefore, on balance, the Exchange 
believes that removing the potential inequity of busting or adjusting 
executions occurring during Limit States or Straddle States outweighs 
any potential benefits from applying Rule 720 during such unusual 
market conditions. Additionally, as discussed above, there are 
additional pre-trade protections in place outside of the Obvious and 
Catastrophic Error Rule that will continue to safeguard customers.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposal will have any 
impact on competition among exchanges or market participants on the 
Exchange, as the proposal provides that market makers may, but are not 
required to, provide liquidity during Limit States and Straddle States, 
and that transactions executed during such states will not be reviewed 
pursuant to Rule 720.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The Exchange has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) by order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File No. SR-ISE-2013-22 on the subject line.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street NE., 
Washington, DC 20549-1090.

All submissions should refer to File No. SR-ISE-2013-22. This file 
number should be included on the subject line if email is used. To help 
the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE., 
Washington, DC 20549, on official business days between the hours of 
10:00 a.m. and 3:00 p.m. Copies of such filing also will be available 
for inspection and copying at the principal office of the Exchange. All 
comments received will be posted without change; the Commission does 
not edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly. All 
submissions should refer to File No. SR-ISE-2013-22 and should be 
submitted on or before April 2, 2013.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\21\
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    \21\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-06087 Filed 3-15-13; 8:45 am]
BILLING CODE 8011-01-P


