
[Federal Register Volume 78, Number 70 (Thursday, April 11, 2013)]
[Notices]
[Pages 21642-21648]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-08473]



[[Page 21642]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-69328; File No. SR-CBOE-2013-030]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Granting Accelerated Approval to Proposed Rule 
Change, as Modified by Amendment Nos. 1 and 2, Relating to the 
Regulation NMS Plan To Address Extraordinary Market Volatility

April 5, 2013.

I. Introduction

    On March 7, 2013, Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to modify its rules to address 
certain option order types, order handling procedures, obvious error 
and market-maker quoting obligations on the Exchange after the 
implementation of the National Market System Plan to Address 
Extraordinary Market Volatility (``Limit up-Limit Down Plan''). The 
proposed rule change was published for comment in the Federal Register 
on March 14, 2013.\3\ On March 26, 2013, CBOE filed Amendment No. 1 to 
the proposed rule change.\4\ On April 4, CBOE filed Amendment No. 2 to 
the proposed rule change.\5\ The Commission received one comment letter 
on the proposed rule change.\6\ This order approves the proposed rule 
change, as modified by Amendment Nos. 1 and 2, on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 69082 (March 8, 
2013), 78 FR 16351 (``Notice'').
    \4\ See Amendment No. 1 dated March 26, 2013 (``Amendment No. 
1''). Amendment No. 1 expanded upon the Exchange's rationale for its 
proposed changes regarding the nullification and adjustment of 
options transactions and agreed to provide the Commission with 
relevant data to assess the impact of the proposal. Additionally, 
the Exchange provided rationale for terminating the HAL auction 
early and cancelling of the market orders, discussed infra. Because 
Amendment No. 1 is technical in nature, it is not subject to notice 
and comment.
    \5\ See Amendment No. 2 dated April 4, 2013 (``Amendment No. 
2''). Amendment No. 2 expanded upon the Exchange's rationale for its 
proposal to accept certain types of market orders during a limit up-
limit down state, its proposal to cancel and replace limit orders 
with market orders during a limit up-limit down state, and its 
proposed treatment of stock-option orders in a limit up-limit down 
state. Because Amendment No. 2 is technical in nature, it is not 
subject to notice and comment.
    \6\ See Letter to Elizabeth M. Murphy, Secretary, Commission, 
from Angelo Evangelou, Associate General Counsel, CBOE, dated April 
4, 2013 (``CBOE Letter'').
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II. Background

    On May 6, 2010, the U.S. equity markets experienced a severe 
disruption that, among other things, resulted in the prices of a large 
number of individual securities suddenly declining by significant 
amounts in a very short time period before suddenly reversing to prices 
consistent with their pre-decline levels.\7\ This severe price 
volatility led to a large number of trades being executed at 
temporarily depressed prices, including many that were more than 60% 
away from pre-decline prices. One response to the events of May 6, 
2010, was the development of the single-stock circuit breaker pilot 
program, which was implemented through a series of rule filings by the 
equity exchanges and by FINRA.\8\ The single-stock circuit breaker was 
designed to reduce extraordinary market volatility in NMS stocks by 
imposing a five-minute trading pause when a trade was executed at a 
price outside of a specified percentage threshold.\9\
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    \7\ The events of May 6 are described more fully in a joint 
report by the staffs of the Commodity Futures Trading Commission 
(``CFTC'') and the Commission. See Report of the Staffs of the CFTC 
and SEC to the Joint Advisory Committee on Emerging Regulatory 
Issues, ``Findings Regarding the Market Events of May 6, 2010,'' 
dated September 30, 2010, available at http://www.sec.gov/news/studies/2010/marketevents-report.pdf.
    \8\ For further discussion on the development of the single-
stock circuit breaker pilot program, see Securities Exchange Act 
Release No. 67091 (May 31, 2012), 77 FR 33498 (June 6, 2012) 
(``Limit Up-Limit Down Plan'' or ``Plan'').
    \9\ See Securities Exchange Act Release Nos. 62884 (September 
10, 2010), 75 FR 56618 (September 16, 2010) and Securities Exchange 
Act Release No. 62883 (September 10, 2010), 75 FR 56608 (September 
16, 2010) (SR-FINRA-2010-033) (describing the ``second stage'' of 
the single-stock circuit breaker pilot) and Securities Exchange Act 
Release No. 64735 (June 23, 2011), 76 FR 38243 (June 29, 2011) 
(describing the ``third stage'' of the single-stock circuit breaker 
pilot).
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    To replace the single-stock circuit breaker pilot program, the 
equity exchanges filed a National Market System Plan \10\ pursuant to 
Section 11A of the Act,\11\ and Rule 608 thereunder,\12\ which featured 
a ``limit up-limit down'' mechanism.
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    \10\ NYSE Euronext filed on behalf of New York Stock Exchange 
LLC (``NYSE''), NYSE Amex LLC (``NYSE Amex''), and NYSE Arca, Inc. 
(``NYSE Arca''), and the parties to the proposed National Market 
System Plan, BATS Exchange, Inc., BATS Y-Exchange, Inc., Chicago 
Board Options Exchange, Incorporated (``CBOE''), Chicago Stock 
Exchange, Inc., EDGA Exchange, Inc., EDGX Exchange, Inc., Financial 
Industry Regulatory Authority, Inc., NASDAQ OMX BX, Inc., NASDAQ OMX 
PHLX LLC, the Nasdaq Stock Market LLC, and National Stock Exchange, 
Inc. (collectively with NYSE, NYSE MKT, and NYSE Arca, the 
``Participants''). On May 14, 2012, NYSE Amex filed a proposed rule 
change on an immediately effective basis to change its name to NYSE 
MKT LLC (``NYSE MKT''). See Securities Exchange Act Release No. 
67037 (May 21, 2012) (SR-NYSEAmex-2012-32).
    \11\ 15 U.S.C. 78k-1.
    \12\ 17 CFR 242.608.
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    The Plan sets forth requirements that are designed to prevent 
trades in individual NMS stocks from occurring outside of the specified 
price bands. The price bands consist of a lower price band and an upper 
price band for each NMS stock. When one side of the market for an 
individual security is outside the applicable price band, i.e., the 
National Best Bid is below the Lower Price Band, or the National Best 
Offer is above the Upper Price band, the Processors \13\ are required 
to disseminate such National Best Bid or National Best Offer \14\ with 
a flag identifying that quote as non-executable. When the other side of 
the market reaches the applicable price band, i.e., the National Best 
Offer reaches the lower price band, or the National Best Bid reaches 
the upper price band, the market for an individual security enters a 
15-second Limit State, and the Processors are required disseminate such 
National Best Offer or National Best Bid with an appropriate flag 
identifying it as a Limit State Quotation. Trading in that stock would 
exit the Limit State if, within 15 seconds of entering the Limit State, 
all Limit State Quotations were executed or canceled in their entirety. 
If the market does not exit a Limit State within 15 seconds, then the 
Primary Listing Exchange will declare a five-minute trading pause, 
which is applicable to all markets trading the security.
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    \13\ As used in the Plan, the Processor refers to the single 
plan processor responsible for the consolidation of information for 
an NMS Stock pursuant to Rule 603(b) of Regulation NMS under the 
Exchange Act. See id.
    \14\ ``National Best Bid'' and ``National Best Offer'' has the 
meaning provided in Rule 600(b)(42) of Regulation NMS under the 
Exchange Act. See id.
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    The Primary Listing Exchange may also declare a trading pause when 
the stock is in a Straddle State, i.e., the National Best Bid (Offer) 
is below (above) the Lower (Upper) Price Band and the NMS Stock is not 
in a Limit State. In order to declare a trading pause in this scenario, 
the Primary Listing Exchange must determine that trading in that stock 
deviates from normal trading characteristics such that declaring a 
trading pause would support the Plan's goal to address extraordinary 
market volatility.\15\
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    \15\ As set forth in more detail in the Plan, all trading 
centers would be required to establish, maintain, and enforce 
written policies and procedures reasonably designed to prevent the 
display of offers below the Lower Price Band and bids above the 
Upper Price Band for an NMS Stock. The Processors would be able to 
disseminate an offer below the Lower Price Band or bid above the 
Upper Price Band that nevertheless may be inadvertently submitted 
despite such reasonable policies and procedures, but with an 
appropriate flag identifying it as non-executable; such bid or offer 
would not be included in National Best Bid or National Best Offer 
calculations. In addition, all trading centers would be required to 
develop, maintain, and enforce policies and procedures reasonably 
designed to prevent trades at prices outside the price bands, with 
the exception of single-priced opening, reopening, and closing 
transactions on the Primary Listing Exchange.

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    On May 31, 2012, the Commission approved the Plan as a one-year 
pilot, which shall be implemented in two phases.\16\ The first phase of 
the Plan shall be implemented beginning April 8, 2013.\17\
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    \16\ See ``Limit Up-Limit Down Plan,'' supra note 8. See also 
Securities Exchange Act Release No. 68953 (February 20, 2013), 78 FR 
13113 (February 26, 2013) (Second Amendment to Limit Up-Limit Down 
Plan by BATS Exchange, Inc., BATS Y- Exchange, Inc., Chicago Board 
Options Exchange, Inc., et al.) and Securities Exchange Act Release 
No. 69062 (March 7, 2013), 78 FR 15757 (March 12, 2013) (Third 
Amendment to Limit Up-Limit Down Plan by BATS Exchange, Inc., BATS 
Y- Exchange, Inc., Chicago Board Options Exchange, Inc., et al.)
    \17\ See ``Second Amendment to Limit Up-Limit Down Plan,'' supra 
note 16.
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III. Description of the Proposed Rule Change, as Modified by Amendment 
Nos. 1 and 2

    In light of and in connection with the Plan, the Exchange proposes 
to amend its rules to address certain option order types, order 
handling procedures, obvious error and market-maker quoting 
obligations.\18\ The Exchange believes these modifications will protect 
investors because when an underlying security is in a limit or straddle 
state (collectively referred to as a ``limit up-limit down state''), 
there will not be a reliable price for the security to serve as a 
benchmark for the price of the option. In addition, the Exchange 
believes these changes are warranted because the width of the options 
markets might be compromised during the limit up-limit down states and, 
thus, the quality of execution may be adversely impacted.
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    \18\ Specifically, the Exchange proposes to make changes to 
Exchange Rules Rule 6.2B, ``Hybrid Opening System, Rule 6.14A, 
``Hybrid Agency Liaison'', Rule 6.25, ``Nullification and Adjustment 
of Options Transactions,'' Rule 6.53, ``Certain Types of Orders 
Defined,'' Rule 6.53C, ``Complex Orders on the Hybrid System,'' Rule 
8.7, ``Obligations of Market-Makers, Rule 8.13, ``Preferred Market-
Maker Program,'' Rule 8.15A, ``Lead Market-Maker in Hybrid 
Classes,'' Rule 8.15B, ``Participation Entitlements of LLMs'', Rule 
8.85, ``DPM Obligations,'' Rule 8.87, ``Participation Entitlement of 
DPMs and e-DPMs,'' and Rule 8.93, ``e-DPM Obligations.'' See Notice 
and Amendment No. 1.
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A. Exchange Rule 6.3A and the Plan

    The Exchange proposes to add to Exchange Rule 6.3A to codify the 
changes occurring throughout its rulebook in connection with the Plan. 
The Exchange proposes to re-name Rule 6.3A, which is currently titled 
``Equity Market Trading Halt'', as ``Equity Market Plan to Address 
Extraordinary Market Volatility''. The Exchange also plans to add new 
rule text that will define the Plan as it applies to the Exchange, and 
will describe the location of the other rule changes associated with 
the Plan. The proposed changes to Rule 6.3A will essentially serve as a 
roadmap for the Exchange's universal changes due to the implementation 
of the Plan.

B. Order Handling During the Limit Up-Limit Down State

    The Exchange proposes to modify Exchange Rules 6.2B, 6.14A, 6.3A, 
6.53 and 6.53C to address how certain Exchange order types will be 
handled when the underlying security of such orders is in a limit up-
limit down state. The proposed rule change will address how market 
orders,\19\ market-on-close,\20\ stop orders,\21\ and stock option 
orders,\22\ will function on the Exchange upon the implementation of 
the Plan. The Exchange is proposing to add language to clarify that: 
(a) Any market order will be returned during limit up-limit down states 
unless it qualifies for certain exceptions; \23\ (b) market-on-close 
orders will not be elected if the underlying security is in a limit up-
limit down state; \24\ (c) stop orders will not be triggered if the 
underlying security is in a limit up-limit down state, but will until 
the end of that state, at which time they will become eligible to be 
triggered; (d) stock-option orders will only execute if the calculated 
stock price is within the permissible bands.\25\ In addition, if a 
message is sent to replace a limit order with a market order while the 
underlying is in a limit up-limit down state, the resting limit order 
will be cancelled and the replaced market order will also be cancelled. 
The Exchange represented that cancelling a market order in this 
scenario is consistent with its treatment of market orders that are 
received during a limit up-limit down state, and cancelling the 
original limit order would be consistent with the Exchange's current 
cancel and replace functionality.\26\
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    \19\ See Exchange Rule 6.53(a) which defines a market order as 
``an order to buy or sell a stated number of options contracts at 
the best price obtainable when the order reaches the post.''
    \20\ See Exchange Rule 6.53(c)(ii) which defines a market-on-
close order designation as an order ``to be executed as close as 
possible to the closing bell, or during the closing rotation, and 
should be near to or at the closing price for the particular series 
of option contracts.''
    \21\ See Exchange Rule 6.53(c)(iii), which defines a stop order 
as a market order ``to buy or sell when the market for a particular 
option contract reaches a specified price on the CBOE floor.'' In 
contrast, a stop-limit order, as defined in Exchange Rule 
6.53(c)(iv), becomes a limit order when the market for the option 
contract reaches a specified price. CBOE does not propose to make 
any modifications to the treatment of stop-limit orders.
    \22\ See Exchange Rule 6.53C(a)(2) which defines a stock-option 
order as ``an order to buy or sell a stated number of units of an 
underlying stock or a security convertible into the underlying stock 
* * * coupled with the purchase or sale of options contract(s) on 
the opposite side of the market.''
    \23\ Specifically, a market order submitted to initiate an 
Automated Improvement Mechanism will be accepted. Market orders will 
also not be returned if the TPH elected to route that order for 
manual handling. With respect to market orders submitted to initiate 
an Automated Improvement Mechanism, the Exchange represented that 
such orders are entered with a contra order. Because these market 
orders are entered as a pair, they are effectively stopped because 
they must execute at a price at or better than the contra order. See 
Amendment No. 2. With respect to market orders routed for manual 
handling, the Exchange represented that those orders are physically 
handled by a broker on the Exchange floor who must affirmatively 
agree to an execution price, and that such orders are thus not 
subject to the same risks a market order may have if such order were 
to execute against unfiltered electronic prices. Id.
    \24\ During closing rotation, the Exchange will continue to re-
evaluate the state of underlying securities for which the overlying 
securities have not yet been closed. If upon re-evaluation the 
underlying security should exit a limit up-limit down state, a 
market-on-close order may be executed.
    \25\ If the calculated price of a stock-option order is not 
within the permissible Price Bands, the stock-option order will be 
routed for manual handling. This provision would help ensure that a 
stock order would not be electronically routed to a stock venue for 
an execution outside of the price bands. In addition, by routing 
stock-option orders for manual handling, these orders will be 
physically handled by a broker on the Exchange floor who must 
affirmatively agree to an execution price. See Amendment No. 2.
    \26\ See Amendment No. 2.
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    The Exchange stated that, although it has determined to continue 
options trading when a stock is in a limit up-limit down state, there 
will not be a reliable price for the underlying security to serve as a 
benchmark for the price of the option. Without a reliable underlying 
stock price, the Exchange stated that there is an enhanced risk of 
errors and improper executions. The Exchange also stated that adding a 
level of certainty for TPHs by specifying the treatment of such orders 
will encourage participation on the Exchange while the underlying 
security is in limit up-limit down states. Accordingly, the Exchange 
believes these order handling changes will best protect market 
participants after the implementation of the Plan by not allowing 
execution at unreasonable prices due to the shift in the stock prices.
    The Exchange also proposes to modify its opening procedures under 
Exchange Rule 6.2B, ``Hybrid Opening System'' (``HOSS''). The Exchange 
proposes to

[[Page 21644]]

add an Interpretation and Policy .07 to clarify that if the underlying 
security for a class of options enters into a limit up-limit down state 
when the class moves to opening rotation, any market orders entered 
that trading day will be cancelled. The Exchange stated that, by 
cancelling the market orders, it will comply with the Plan by not 
allowing orders outside of the Price Bands to execute. As an exception, 
market orders that are considered limit orders pursuant to Rule 
6.13(b)(iv) and entered the previous trading day will remain in the 
book. The Exchange is proposing to allow such market orders to remain 
in the Book because these essentially act as limit orders at the 
minimum increment.
    Next, the Exchange proposes to modify Exchange Rule 6.14A, ``Hybrid 
Agency Liaison (``HAL''). This functionality provides automated order 
handling in designated classes trading on the Hybrid System for 
qualifying electronic orders that are not automatically executed by the 
Hybrid System.\27\ When the Exchange receives a qualifying order that 
is marketable against the National Best Bid or Offer (``NBBO'') and/or 
the Exchange's best bid or offer (``BBO''),\28\ HAL electronically 
exposes the order \29\ at the NBBO price to allow Market-Makers 
appointed in that class, as well as all Trading Permit Holders 
(``TPHs'') acting as agent for orders, at the top of the Exchange's 
book in the relevant series (or all TPHs if allowed by the Exchange) to 
step up to the NBBO price.
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    \27\ Currently, the Exchange determines the eligible order size, 
eligible order types, eligible origin code (i.e., public customer 
orders, non-Market-Maker broker-dealer orders and Market-Maker 
broker-dealer orders), and classes in which HAL is activated. See 
Exchange Rule 6.14A(a).
    \28\ HAL will not electronically expose the order if the 
Exchange's quotation contains resting orders and does not contain 
sufficient Market-Maker quotation interest to satisfy the entire 
order.
    \29\ The duration of the exposure period may not exceed one 
second. See Exchange Rule 6.14A(c) (describing the manner in which 
an exposed order is allocated under HAL); see also Exchange Rule 
6.14A(d) (listing the circumstances in which an exposure period 
would terminate early).
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    The Exchange proposes to amend Rule 6.14A to modify the functioning 
of HAL with respect to market orders when the underlying security of 
the option is in a limit up-limit down state. Under the proposal, if an 
underlying security enters a limit up-limit down state while a market 
order is being exposed through HAL, the auction will end early, i.e., 
upon the entering of the limit up-limit down state. Additionally, any 
unexecuted portion of the market order would be cancelled. The Exchange 
stated that because there is an uncertainty of market prices during a 
limit up-limit down state, terminating the HAL auction early and 
cancelling the market order will ensure that market orders do not 
receive an unanticipated price.\30\ As such, the proposed rule changes 
would protect market participants by ensuring that they do not receive 
an executed order with an unanticipated price due to the change in the 
underlying security.
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    \30\ See Amendment No. 1.
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    The Exchange also proposes to modify the treatment of complex 
orders on the Hybrid System and the Complex Order Auction (``COA'') 
process. Generally, on a class-by-class basis, the Exchange may 
activate COA, which is a process by which eligible complex orders \31\ 
are given an opportunity for price improvement before being booked in 
the electronic complex order book (``COB'') or on a PAR workstation. 
Upon receipt of a COA-eligible order and a request from a TPH 
representing the order that such order be subjected to a COA, the 
Exchange will send a request for responses (``RFR'') message to all 
TPHs who have elected to receive RFR messages.\32\ Each Market-Maker 
with an appointment in the relevant option class and each TPH acting as 
agent for orders resting at the top of the COB in the relevant options 
series may then submit responses to the RFR message during the Response 
Time Interval.\33\
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    \31\ An eligible complex order, referred to in Rule 6.53C as a 
``COA-eligible order,'' means a complex order that, as determined by 
the Exchange on a class-by-class basis, is eligible for a COA 
considering the order's marketability (defined as a number of ticks 
away from the current market), size, complex order type and complex 
order origin type (i.e., non-broker-dealer public customer, broker-
dealers that are not Market-Makers or specialists on an options 
exchange, and/or Market-Makers or specialists on an options 
exchange). All determinations by the Exchange on COA-eligible order 
parameters are announced to Trading Permit Holders by Regulatory 
Circular. See Rule 6.53C(d)(i)(2) and Interpretation and Policy .01 
to Rule 6.53C.
    \32\ See Exchange Rule 6.53C(d)(ii). The RFR message will 
identify the component series, the size of the COA-eligible order 
and any contingencies, but will not identify the side of the market.
    \33\ See Exchange Rule 6.53C(d)(iii). A ``Response Time 
Interval'' means the period of time during which responses to the 
RFR may be entered, the length of which is determined by the 
Exchange on a class-by-class basis but may not exceed three seconds. 
See Rule 6.53C(d)(iii)(2).
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    The Exchange proposes to add to the COA rule that if, during COA of 
a market order, the underlying security of an option enters a limit up-
limit down state, the COA will end upon the entering of that state and 
the remaining portion of the order, if a market order, will cancel. The 
Exchange believes this change will best protect investors because, once 
the underlying enters a limit up-limit down state, pricing in the 
options markets may change, resulting in executions at unexpected 
prices.

C. Market Maker Obligations and Participation Entitlements

    The Exchange proposes to eliminate all market maker obligations for 
options in which the underlying security is in a limit up-limit down 
state. Currently, Exchange Rules 8.7, 8.13, 8.15A, 8.85, and 8.93 
impose certain obligations on Market-Makers,\34\ PMMs,\35\ LMMs,\36\ 
DPMs,\37\ and e-DPMs,\38\ respectively, including obligations to 
provide continuous electronic quotes.
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    \34\ See Exchange Rule 8.1, which defines a ``Market-Maker'' as 
``an individual Trading Permit Holder or a TPH organization that is 
registered with the Exchange for the purpose of making transactions 
as a dealer specialist on the Exchange * * *.''
    \35\ See Exchange Rule 8.13, which defines a ``Preferred Market-
Maker'' as a specific Market-Maker designated by a Trading Permit 
Holder to receive that Trading Permit Holder's orders in a specific 
class.
    \36\ See Exchange Rule 8.15A, which defines a ``Lead Market-
Maker'' as a Market-Maker in good standing appointed by the Exchange 
``in an option class for which a DPM has not been appointed * * *.''
    \37\ See Exchange Rule 8.80, which defines a ``Designated 
Primary Market-Maker'' as a ``TPH organization that is approved by 
the Exchange to function in allocated securities as a Market-Maker * 
* * and is subject to the obligations under Rule 8.85 * * *.''
    \38\ See Exchange Rule 8.92, which defines an ``Electronic DPM'' 
as a ``TPH Organization that is approved by the Exchange to remotely 
function in allocated option classes as a DPM and to fulfill certain 
obligations required of DPMs * * *.''
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    The Exchange proposes to eliminate all market maker quoting 
obligations \39\ in series of options when the underlying security is 
currently in a limit up-limit down state. According to the Exchange, 
eliminating all Market Maker obligations in connection with the 
implementation of the Plan is the most effective way to ensure the 
options markets will not be compromised when the underlying security 
enters a limit up-limit down state. Specifically, there may not be 
reliable prices for an underlying security during a limit up-limit down 
state. Additionally, it may be difficult or not possible for a market 
participant to hedge the purchase or sale of an option if the bid or 
offer of an underlying security may not be executable due to a limit 
up-limit down state. Given the possible effects of the limit up-limit 
down state, the Exchange anticipates that Exchange Market-Makers may be 
forced to change behaviors during these periods. In an effort to 
protect the investors in the options market while the underlying 
security is in a limit up-limit down state, the Exchange believes that 
eliminating quoting obligations is the more effective way for this 
protection.
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    \39\ See Notice, supra note 3.
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    Although the Exchange is proposing to relieve market makers of 
their quoting

[[Page 21645]]

obligations when the underlying is in a limit up-limit down state, the 
Exchange is proposing that PMMs, LMMs, DPMs and e-DPMs may still 
receive participation entitlements pursuant to the proposed rules in 
all series in their assigned classes in which they are quoting, even in 
series in which they are not required to provide continuous electronic 
quotes under the Exchange Rules. The Exchange stated that market makers 
already receive participation entitlements in series in which they are 
not required to quote; thus, under the proposed rule change, the market 
would continue to function as it does now with respect to how 
entitlements are allocated to Market-Makers. The Exchange believes this 
benefit is appropriate, as it incentivizes Market-Makers to quote in as 
many series as possible in their appointed classes, even those series 
in which the underlying security has entered into a limit up-limit down 
state. The Exchange stated that it is attempting to better encourage 
Market-Makers to quote even though they will not have the obligation. 
If market makers do choose to quote, the Exchange believes they should 
be entitled to receive the entitlement for such quoting as appropriate.

D. Nullification and Adjustment of Options Transactions

    In connection with the implementation of the Plan, the Exchange 
proposes to adopt Interpretation and Policies .06 to Rule 6.25 to 
exclude transactions in options that overlay a security during a Limit 
State or Straddle State from the obvious error pricing provision in 
Rule 6.25(a)(1) for a one year pilot basis from the date of adoption of 
the proposed rule change. Additionally, the Exchange proposes to 
specify that electronic transactions in options that overlay an NMS 
stock that occur during a Limit State or Straddle State may be reviewed 
on an Exchange motion pursuant to Rule 6.25(b)(3). The Exchange also 
proposes to provide the Commission with data and analysis during the 
duration of the pilot as requested.
    Under Rule 6.25, an Obvious Price Error occurs when the execution 
price of an electronic transaction is above or below the theoretical 
price for the series by a specified amount. Pursuant to Rule 
6.25(a)(1)(i), the theoretical price of an option series is currently 
defined, for series traded on at least one other options exchange, as 
the last national best bid price with respect to an erroneous sell 
transaction, and the last national best offer price with respect to an 
erroneous buy transaction, just prior to the trade. In certain 
circumstances, Trading Officials have the discretion to determine the 
theoretical price pursuant to Rule 6.25(a)(1)(iv).\40\
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    \40\ Rule 6.25(a)(1)(iv) provides there are no quotes for 
comparison, or if the bid/ask differential of the national best bid 
and offer for the affected series just prior to the erroneous 
transaction was at least two times the permitted bid/ask 
differential determined by the Exchange, designated Trading 
Officials will determine the theoretical price.
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    The Exchange believes that neither method is appropriate during a 
Limit State or Straddle State. In Amendment No. 1, the Exchange noted 
that during a Limit State or Straddle State, options prices may deviate 
substantially from those available prior to or following the 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. The Exchange noted that 
determining theoretical value in such a situation would be often times 
be very subjective rather than an objective determination and would 
give rise to additional uncertainty and confusion for investors. 
Similarly, 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 would produce undesirable effects.
    Ultimately, the Exchange believes that adding certainty to the 
execution of limit orders in these situations should encourage market 
participants to continue to provide liquidity to the Exchange, thus 
promoting a fair and orderly market. On balance, the Exchange believes 
that removing the potential inequity of nullifying or adjusting 
executions occurring during Limit States or Straddle States outweighs 
any potential benefits from applying these provisions during such 
unusual market conditions.
    Therefore, the Exchange proposes to adopt Interpretation and Policy 
.06 to Rule 6.25 to provide that transactions executed during a Limit 
State or Straddle State are not subject to the obvious pricing error 
provision in Rule 6.25(a)(1). In addition, amended Rule 6.25 will 
include a qualification that nothing in the proposed rule change will 
prevent transactions in options that overlay a security in a Limit 
State or Straddle State from being reviewed on an Exchange motion 
pursuant to Rule 6.25(b)(3). According to the Exchange, this safeguard 
will provide the flexibility to act when necessary and appropriate, 
while also providing market participants with certainty that trades 
they effect with quotes and/or orders having limit prices will stand 
irrespective of subsequent moves in the underlying security. The right 
to review on Exchange motion electronic transactions that occur during 
a Limit State or Straddle State under this provision, according to the 
Exchange, would enable the Exchange to account for unforeseen 
circumstances that result in obvious or catastrophic errors for which a 
nullification or adjustment may be necessary in order to preserve the 
interest of maintaining a fair and orderly market and for the 
protection of investors. The Exchange also proposes to provide the 
Commission with data and analysis during the duration of the pilot as 
requested.

IV. 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 rules and 
regulations thereunder applicable to a national securities 
exchange.\41\ In particular, the Commission finds that the proposed 
rule change is consistent with Section 6(b)(5) of the Act,\42\ which, 
among other things, requires a national securities exchange to be so 
organized and have the capacity to be able to carry out the purposes of 
the Act and to enforce compliance by its members and persons associated 
with its members with the provisions of the Act, the rules and 
regulations thereunder, and the rules of the exchange, and is designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, to foster cooperation and 
coordination with persons engaged in regulation, clearing, settling, 
processing information with respect to, and facilitating transactions 
in securities, 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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    \41\ In approving the proposed rule changes, the Commission has 
considered their impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 78c(f).
    \42\ 15 U.S.C. 78f(b).
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A. Exchange Rule 6.3A and the Plan

    Exchange Rule 6.3A lists changes to Exchange order types, order 
handling, obvious error, and market-maker quoting obligations that the 
Exchange is making in connection with the implementation of the Plan. 
The Exchange believes that the proposed changes to Rule 6.3A will 
describe to TPHs and other market participants where to find the 
changes associated

[[Page 21646]]

with the Plan's implementation. Accordingly, the Commission finds that 
this change promotes clarity in connection with CBOE's proposed changes 
in response to the Limit up-Limit Down Plan and is therefore consistent 
with the Act.

B. Order Handling During the Limit Up-Limit Down State

    As detailed above, the Exchange proposes to add language to clarify 
that: (a) market orders, with certain exceptions, will be returned 
during limit up-limit down states, (b) market-on-close orders will not 
be elected if the underlying security is in a limit up-limit down 
state, (c) stop orders will not be triggered while the underlying 
security is in a limit up-limit down state, and (d) stock-option orders 
will only execute if the calculated stock price is within the 
permissible bands, unless such order is routed for manual handling. In 
addition, during a limit up-limit down state, if a message is sent to 
replace a limit order with a market order, the resting limit order will 
be cancelled and the replaced market order will also be cancelled.
    The Commission finds that the Exchange's proposed method of 
handling such orders is consistent with Section 6(b)(5) of the Act. 
When the underlying stock enters a limit up-limit down state, the lack 
of a reliable price in that market could affect the options markets in 
various ways, including wider spreads and less liquidity. This could 
potentially mean that market orders, which contain no restrictions on 
the price at which they may execute, could receive executions at 
unintended prices if executed during the limit up-limit down state. As 
such, the proposed changes to reject market orders and market-on-close 
orders if the underlying is in a limit up-limit down state, to not 
trigger stop orders if the underlying is in a limit up-limit down 
state, and to cancel market orders that replace limit orders when the 
underlying is in a limit up-limit down state, are reasonably designed 
to prevent such orders from being executed at potentially unexpected 
prices.
    At the same time, the proposed exceptions to the treatment of these 
orders--accepting market orders that are submitted to initiate an 
Automated Price Improvement Mechanism, or which are routed for manual 
handling--are designed to take into account that market orders 
submitted in these ways may not be at the same risk as other market 
orders for executions at unexpected prices. Specifically, market orders 
submitted through the Automated Price Improvement Mechanism are 
submitted as pairs, and are effectively stopped because they must 
execute at a price at or better than the contra order. With respect to 
market orders routed for manual handling, such orders are physically 
handled by a broker on the Exchange floor who must affirmatively agree 
to an execution price, as opposed to simply executing that order 
against electronic prices. Similarly, the Exchange's proposal to route 
a stock-option order for manual handling when the underlying is in a 
limit up-limit down state allows such orders to be physically handled 
by a broker on the Exchange floor who must affirmatively agree to an 
execution price.
    The Exchange proposes to add an Interpretation and Policy .07 to 
Rule 6.2B which states that if the underlying security for a class of 
options enters into a limit up-limit down state when the class moves to 
opening rotation, any market orders entered that trading day will be 
cancelled. However, market orders that are considered limit orders 
pursuant to Rule 6.13(b)(iv) and entered the previous trading day will 
remain in the Book and can essentially act as limit orders at the 
minimum increment.
    The Commission finds that these changes are consistent with the Act 
in that they are reasonably designed to counter potential price 
dislocations that may occur if the underlying enters a limit up-limit 
down state during the opening by preventing market orders, which 
contain no restrictions on the price at which they may execute, from 
being executed at potentially unintended prices. At the same time, this 
proposal allows market orders that are essentially limit orders to 
continue to participate in the opening process without a similar risk 
of an execution at an unintended price.
    The Exchange also proposes that, if an underlying security enters a 
limit up-limit down state while a market order is being exposed through 
HAL, the auction will end early, and any unexecuted portion of the 
market order would be cancelled. The Commission believes that this 
provision will provide certainty to options market participants on how 
market orders submitted to HAL will be handled during limit up-limit 
down states. In addition, the Commission finds that this provision is 
consistent with the Act in that it is reasonably designed to counter 
potential price dislocations that may occur if the underlying enters a 
limit up-limit down state while the HAL functionality is underway by 
preventing market orders, which contain no restrictions on the price at 
which they may execute, from being executed at potentially unintended 
prices.
    The Exchange proposes to amend the COA rule so that, if during a 
COA of a market order, the underlying security of an option enters a 
limit up-limit down state, the COA will end and the remaining portion 
of the order, if a market order, will cancel. As with the proposed 
change to HAL, the Commission believes that this provision is 
consistent with the Act in that it will provide certainty to options 
market participants on how market orders submitted to COA will be 
handled during limit up-limit down states. In addition, the Commission 
finds that this provision is reasonably designed to counter potential 
price dislocations that may occur if the underlying enters a limit up-
limit down state while a COA is underway by preventing market orders, 
which contain no restrictions on the price at which they may execute, 
from being executed at potentially unintended prices.

C. Market Maker Obligations

    The Commission finds that the proposal to suspend a market maker's 
obligations when the underlying security is in a limit up-limit down 
state is consistent with the Act. During a limit up-limit down state, 
there may not be a reliable price for the underlying security to serve 
as a benchmark for market makers to price options. In addition, the 
absence of an executable bid or offer for the underlying security will 
make it more difficult for market makers to hedge the purchase or sale 
of an option. Given these significant changes to the normal operating 
conditions of market makers, the Commission finds that the Exchange's 
decision to suspend a market maker's obligations in these limited 
circumstances is consistent with the Act. The Commission notes, 
however, that the Plan was approved on a pilot basis and its 
Participants will monitor how it is functioning in the equity markets 
during the pilot period. To this end, the Commission expects that, upon 
implementation of the Plan, the Exchange will continue monitoring the 
quoting requirements that are being amended in this proposed rule 
change and determine if any necessary adjustments are required to 
ensure that they remain consistent with the Act.
    The Commission also finds that the proposal to maintain 
participation entitlements for market makers in all series in their 
assigned classes in which they are quoting, including in series for 
which the underlying security is in a limit up-limit down state and for 
which they are not required to provide continuous electronic quotes 
under the Exchange Rules, is consistent with the

[[Page 21647]]

Act. To the extent that market makers are only eligible for 
participation entitlements if they are quoting at the best price on the 
Exchange, this proposal is reasonably designed to incentivize Market-
Makers to quote more aggressively when the underlying security has 
entered into a limit up-limit down state than they might otherwise 
quote, potentially providing additional liquidity and price discovery. 
To the extent that, under this proposal, market makers would receive 
participation entitlements in series in which they are not required to 
quote, the Commission notes that this aspect of the proposal is 
consistent with the current application of participation entitlements.

D. Nullification and Adjustment of Options Transactions

    The Commission finds that the Exchange's proposal to suspend 
certain aspects of Rule 6.25 during a Limit State or Straddle State is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities exchange. 
Specifically, the Commission finds that the proposal is consistent with 
Section 6(b)(5) of the Act,\43\ in that it is designed to prevent 
fraudulent and manipulative acts and practices, promote just and 
equitable principles of trade, foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, remove impediments to and perfect the mechanism of a free 
and open market and a national market system, and, in general, protect 
investors and the public interest.
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    \43\ 15 U.S.C. 78f(b)(5).
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    In Amendment No. 1, the Exchange notes its belief that suspending 
certain aspects of Rule 6.25 during a Limit State or Straddle State 
will ensure that limit orders that are filled during a Limit or 
Straddle State will have certainty of execution in a manner that 
promotes just and equitable principles of trade and removes impediments 
to, and perfects the mechanism of, a free and open market and a 
national market system. The Exchange believes the application of the 
current rule would be impracticable given what it perceives will be the 
lack of a reliable NBBO in the options market during Limit States and 
Straddle States, and that the resulting actions (i.e., nullified trades 
or adjusted prices) may not be appropriate given market conditions. In 
addition, given the Exchange's view that options prices during Limit 
States or Straddle States may deviate substantially from those 
available shortly following the Limit State or Straddle State, the 
Exchange believes that providing market participants time to re-
evaluate a transaction executed during a Limit State or Straddle State 
will create an unreasonable adverse selection opportunity that will 
discourage participants from providing liquidity during Limit States or 
Straddle States. Ultimately, the Exchange believes that adding 
certainty to the execution of orders in these situations should 
encourage market participants to continue to provide liquidity to the 
Exchange during Limit States and Straddle States, thus promoting fair 
and orderly markets.
    The Exchange, however, has proposed this rule change based on its 
expectations about the quality of the options market during Limit 
States and Straddle States. The Exchange states, for example, that it 
believes that application of the obvious and catastrophic error rules 
would be impracticable given the potential for lack of a reliable NBBO 
in the options market during Limit States and Straddle States. Given 
the Exchange's recognition of the potential for unreliable NBBOs in the 
options markets during Limit States and Straddle States, the Commission 
is concerned about the extent to which investors may rely to their 
detriment on the quality of quotations and price discovery in the 
options markets during these periods. This concern is heightened by the 
Exchange's proposal to exclude electronic trades that occur during a 
Limit State or Straddle State from the obvious pricing error provisions 
of Rule 6.25(a)(1) and the nullification or adjustment provisions of 
Rule 6.25. The Commission urges investors and market professionals to 
exercise caution when considering trading options under these 
circumstances. Broker-dealers also should be mindful of their 
obligations to customers that may or may not be aware of specific 
options market conditions or the underlying stock market conditions 
when placing their orders.
    While the Commission remains concerned about the quality of the 
options market during the Limit States and Straddle States, and the 
potential impact on investors of executing in this market without the 
protections of the obvious or catastrophic error rules that are being 
suspended during the Limit and Straddle States, it believes that 
certain aspects of the proposal could help mitigate those concerns.
    First, despite the removal of obvious and catastrophic error 
protection during Limit States and Straddle States, the Exchange states 
that there are additional measures in place designed to protect 
investors. For example, the Exchange states in Amendment No. 1 that by 
rejecting market orders and not electing stop orders, only those orders 
with a limit price will be executed during a Limit State or Straddle 
State. Additionally, the Exchange notes the existence of SEC Rule 15c3-
5 requiring broker-dealers to have controls and procedures in place 
that are reasonably designed to prevent the entry of erroneous orders. 
Therefore, on balance, the Exchange believes that removing the 
potential inequity of nullifying or adjusting executions occurring 
during Limit States or Straddle States outweighs any potential benefits 
from applying certain provisions during such unusual market conditions.
    The Exchange also believes that the aspect of the proposed rule 
change that will continue to allow the Exchange to review on its own 
motion electronic trades that occur during a Limit State or a Straddle 
State is consistent with the Act because it would provide flexibility 
for the Exchange to act when necessary and appropriate to nullify or 
adjust a transaction and will enable the Exchange to account for 
unforeseen circumstances that result in obvious errors for which a 
nullification or adjustment may be necessary in order to preserve the 
interest of maintaining a fair and orderly market and for the 
protection of investors. The Exchange represents that it will 
administer this provision in a manner that is consistent with the 
principles of the Act. In addition, the Exchange has represented that 
it will create and maintain records relating to the use of the 
authority to act on its own motion during a Limit State or Straddle 
State.
    Finally, the Exchange has proposed that the changes be implemented 
on a one year pilot basis. The Commission believes that it is important 
to implement the proposal as a pilot. The one year pilot period will 
allow the Exchange time to assess the impact of the Plan on the options 
marketplace and allow the Commission to further evaluate the effect of 
the proposal prior to any proposal or determination to make the changes 
permanent. To this end, the Exchange has committed to: (1) Evaluate the 
options market quality during Limit States and Straddle States; (2) 
assess the character of incoming order flow and transactions during 
Limit States and Straddle States; and (3) review any complaints from 
members and their customers concerning executions during Limit States 
and Straddle States. Additionally, the Exchange has agreed to provide 
the Commission with data requested to evaluate the impact of the 
elimination of

[[Page 21648]]

the obvious error rule, including data relevant to assessing the 
various analyses noted above. On April 4, 2013, the Exchange submitted 
a letter stating that it would provide specific data to the Commission 
and the public and certain analysis to the Commission to evaluate the 
impact of Limit States and Straddle States on liquidity and market 
quality in the options markets.\44\ This will allow the Commission, the 
Exchange, and other interested parties to evaluate the quality of the 
options markets during Limit States and Straddle States and to assess 
whether the additional protections noted by the Exchange are sufficient 
safeguards against the submission of erroneous trades, and whether the 
Exchange's proposal appropriately balances the protection afforded to 
an erroneous order sender against the potential hazards associated with 
providing market participants additional time to review trades 
submitted during a Limit State or Straddle State.
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    \44\ In particular, the Exchange represented that, at least two 
months prior to the end of the one year pilot period of proposed 
Interpretation and Policy .06 to Rule 6.25, it would provide to the 
Commission an evaluation of (i) the statistical and economic impact 
of Straddle States on liquidity and market quality in the options 
market and (ii) whether the lack of obvious error rules in effect 
during the Limit States and Straddle States are problematic. In 
addition, the Exchange represented that each month following the 
adoption of the proposed rule change it would provide to the 
Commission and the public a dataset containing certain data elements 
for each Limit State and Straddle State in optionable stocks. The 
Exchange stated that the options included in the dataset will be 
those that meet the following conditions: (i) the options are more 
than 20% in the money (strike price remains greater than 80% of the 
last stock trade price for calls and strike price remains greater 
than 120% of the last stock trade price for puts when the Limit 
State or Straddle State is reached); (ii) the option has at least 
two trades during the Limit State or Straddle State; and (iii) the 
top ten options (as ranked by overall contract volume on that day) 
meeting the conditions listed above. For each of those options 
affected, each dataset will include, among other information: stock 
symbol, option symbol, time at the start of the Limit State or 
Straddle State and an indicator for whether it is a Limit State or 
Straddle State. For activity on the exchange in the relevant 
options, the Exchange has agreed to provide executed volume, time-
weighted quoted bid-ask spread, time-weighted average quoted depth 
at the bid, time-weighted average quoted depth at the offer, high 
execution price, low execution price, number of trades for which a 
request for review for error was received during Straddle States and 
Limit States, an indicator variable for whether those options 
outlined above have a price change exceeding 30% during the 
underlying stock's Limit State or Straddle State compared to the 
last available option price as reported by OPRA before the start of 
the Limit or Straddle state (1 if observe 30% and 0 otherwise), and 
another indicator variable for whether the option price within five 
minutes of the underlying stock leaving the Limit State or Straddle 
State (or halt if applicable) is 30% away from the price before the 
start of the Limit State or Straddle state. See CBOE Letter, supra 
note 6.
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    In addition, the Commission finds good cause, pursuant to Section 
19(b)(2) of the Act \45\ for approving the proposed rule change on an 
accelerated basis. This proposal is related to the Plan, which will 
become operative on April 8, 2013, and aspects of the proposal, such as 
rejecting market orders and not electing Stop Orders during a limit up-
limit down state, are designed to prevent such orders from receiving 
poor executions during those times. In granting accelerated approval, 
the proposed rule change, and its corresponding protections, will take 
effect upon the Plan's implementation date. Accordingly, the Commission 
finds that good cause exists for approving the proposed rule change on 
an accelerated basis.
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    \45\ 15 U.S.C. 78s(b)(2)
---------------------------------------------------------------------------

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\46\ that the proposed rule change (SR-CBOE-2013-030), as modified 
by Amendments Nos. 1 and 2, be, and it hereby is, approved on an 
accelerated basis.
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    \46\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\47\
---------------------------------------------------------------------------

    \47\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-08473 Filed 4-10-13; 8:45 am]
BILLING CODE 8011-01-P


