
[Federal Register Volume 78, Number 121 (Monday, June 24, 2013)]
[Notices]
[Pages 37870-37873]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-14962]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-69782; File No. SR-ISE-2013-38]


Self-Regulatory Organizations; International Securities Exchange, 
LLC; Notice of Filing of Proposed Rule Change Related to Market Maker 
Risk Parameters and Complex Orders

June 18, 2013.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on June 5, 2013, the International Securities Exchange, LLC (the 
``Exchange'' or the ``ISE'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III 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 mitigate market maker risk by requiring 
market makers to enter values in the Exchange-provided risk parameters 
and by limiting the types of complex orders that can leg-into the 
regular market. The text of the proposed rule 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

[[Page 37871]]

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 
Statutory Basis for, Proposed Rule Change

1. Purpose
    On [sic] Pursuant to ISE Rule 722 and 804, the Exchange currently 
provides functionality that will automatically remove a market maker's 
quotes in all series of an options class when certain parameter 
settings are triggered. Specifically, there are four parameters that 
can be set by market makers on a class-by-class basis. These parameters 
are available for market maker quotes in single options series and for 
market maker quotes in complex instruments on the complex order book. 
Market makers establish a time frame during which the system 
calculates: (1) The number of contracts executed by the market maker in 
an options class; (2) the percentage of the total size of the market 
maker's quotes in the class that has been executed; (3) the absolute 
value of the net between contracts bought and contracts sold in an 
options class, and the absolute value of the net between (a) calls 
purchased plus puts sold, and (b) calls sold plus puts purchased. The 
market maker establishes limits for each of these four parameters, and 
when the limits are exceeded within the prescribed time frame, the 
market makers quotes are removed.\3\
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    \3\ The Exchange is proposing certain non-substantive changes to 
the text of Rules 722 and 804 for clarity. The changes shorten the 
first sentence in Rule 804 by deleting ``if the market maker trades, 
in the aggregate across all series of an options class during a 
specified time period'' and to delete ``(established by the market 
maker), within a time frame specified by the market maker'' as the 
text might be confusing in its current form and is redundant with 
other text within the Rule. To assure clarity, the Exchange also 
proposes to specify that the first parameter is a number of 
``total'' contracts ``in the class,'' and to specify that the fourth 
parameter is a net value based on puts and calls purchased and sold 
``in the class.'' Finally, the Exchange proposes to use a uniform 
construction of ``the specified . . .'' for each of the four 
parameters. The same clarifying changes are also proposed with 
respect to Rule 722, as the language in both rules is identical 
except for the fact that Rule 722 applies to market maker quotes for 
complex orders. The Exchange is not proposing to alter the operation 
of the functionality, other than to make use of the parameters 
mandatory.
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    The purpose of this functionality is to allow market makers to 
provide liquidity across potentially hundreds of options series without 
being at risk of executing the full cumulative size of all such quotes 
before being given adequate opportunity to adjust their quotes. For 
example, if a market maker can enter quotes with a size of 20 contracts 
in 150 series of an options class, its total potential exposure is 3000 
contracts in the options class. To mitigate the risk of executing all 
3000 contracts without evaluating its positions, the market maker risk 
functionality will automatically remove its quotes in all series of the 
options class after it has executed a specified number of contracts 
(e.g., 100) in series of that options class during a specified time 
period (e.g., 5 seconds).
    To assure that all quotations are firm for their full size, the 
parameter calculations occur after an execution against a market 
maker's quote takes place. For example, if a market maker has set a 
parameter of 100 contracts during a 5 second interval for an options 
class, and has executed a total of 95 contracts in the options class 
within the previous 3 seconds, a quote in a series of that class with a 
size of 20 contracts continues to be firm for all 20 contracts. In this 
example, an incoming order could execute all 20 contracts of the quote, 
and following the execution, the total size parameter would add 20 
contracts to the running total of 95. Since the total size executed 
within the 5 second time frame exceeds the 100 contracts established by 
the market maker for the options class, all of the market maker's 
quotes in the options class would be removed. The market maker would 
then enter new quotes in the class.
    Use of these risk management tools has always been voluntary under 
the rules. Similarly, from a technical perspective, market makers 
currently do not need to enter any values into the applicable fields, 
and thus effectively can choose not to use these tools. The Exchange 
proposes to amend the rule to make it mandatory for market makers to 
enter values into all four of the quotation risk management parameters 
for all options classes in which it enters quotes. The purpose of the 
rule change is to prevent market makers from inadvertently entering 
quotes without risk-management parameters. In this respect, the 
Exchange notes that all ISE market makers currently use the parameters 
when entering quotes. However, it is possible that a market maker could 
inadvertently enter quotes without populating one or more of the risk 
parameters, resulting in the member being exposed to much more risk 
than it intended. Accordingly, ISE market makers have requested that 
the Exchange modify the trading system to reject quotes if there are 
any missing risk management values for the options class.
    While entering values into the quotation risk parameters will be 
mandatory to prevent an inadvertent exposure to risk, the Exchange 
notes that market makers who prefer to use their own risk-management 
systems can enter values that assure the Exchange-provided parameters 
will not be triggered.\4\ Accordingly, the proposal does not require 
members to manage their risk using the Exchange-provided tools.
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    \4\ For example, a market maker could set the value for the 
total number of contracts executed in a class at a level that 
exceeds the total number of contracts the market maker actually 
quotes in an options class.
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    The Exchange also proposes to amend Rule 722 to limit a potential 
source of unintended market maker risk related to how the market maker 
risk parameters under Rule 804 are calculated when complex orders leg-
into the regular market.\5\ As discussed above, by checking the risk 
parameters following each execution in an options series, the risk 
parameters allow market makers to provide liquidity across multiple 
series of an options class without being at risk of executing the full 
cumulative size of all such quotes. This is not the case, however, when 
a complex order legs-into the market. Because the execution of each leg 
is contingent on the execution of the other legs, the execution of all 
the legs in the regular market is processed as a single transaction, 
not as a series of individual transactions.
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    \5\ Pursuant to ISE Rule 722(b)(3)(ii), complex orders may be 
executed against bids and offers on the Exchange for the individual 
legs of the complex order, provided the complex order can be 
executed while maintaining a permissible ratio by such bids and 
offers.
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    For example, if individual orders to buy 10 contracts for the Jan 
30 call, Jan 35 call, Jan 40 call, Jan 45, and Jan 50 calls are 
entered, each is processed as it is received and the market maker 
quotation parameters are calculated following the execution of each 10-
contract order. However, if a complex order to buy all five of these 
strikes ten times is entered and is executed against bids and offers 
for the individual series, the market maker parameters for quotes in 
the regular market are calculated following the execution of all 50 
contracts. In the example discussed previously, when the market maker 
had set a limit of 100 contracts for the options class and had executed 
95 contracts, the amount by which the next transaction might exceed 100 
is limited to the largest size of its quote in a single series of the 
options class. In that example, since the largest size the market maker 
was quoting in any one series was 20 contracts, the market maker could 
not have exceeded the 100 contract trigger by more than 15

[[Page 37872]]

contracts (95 + 20 = 115). With respect to a complex order with five 
legs 20 times, the next transaction against the market maker's quotes 
potentially could be as large as 100 contracts (depending upon whether 
there are other market participants same price), creating the potential 
in this example that the market maker could exceed the 100 contract 
limit by 95 contracts (95 + 100 = 195) instead of 15.
    As the example demonstrates, the legging-in of complex orders 
presents higher risk to market makers as compared to regular orders 
being entered in multiple series of an options class in the regular 
market as it allows market makers to exceed their parameters by a 
greater number of contracts. Because this risk is directly proportional 
to the number of legs associated with a complex order, ISE market 
makers have requested that the Exchange prevent complex orders from 
legging into the market if they have a large number of legs. The 
Exchange therefore proposes to limit the legging functionally to 
complex orders with no more than either two or three legs, as 
determined by the Exchange on a class basis.\6\ The Exchange notes in 
this respect that over 85% of all complex orders have only two legs and 
that very few complex orders are entered with more than three legs. The 
Exchange believes that the potential risk to market makers in the 
regular market of allowing orders with more than three legs (in some 
cases more than two legs) to leg-into the market, far out-weighs the 
potential benefit of offering such functionality to a very limited 
number of orders.
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    \6\ The Exchange will issue a circular to members identifying 
the options classes for which legging is limited to complex orders 
with two legs and those for which legging is limited to complex 
order with three legs. The Exchange will provide members with 
reasonable notice prior to change the limit applicable to an options 
class.
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    Complex orders with more than three legs (in some cases more than 
two legs) that could leg into the market except for the proposed 
limitation will be available for execution on the complex order book. 
The Exchange notes in this respect that the execution priority rules 
contained in ISE Rule 722(b)(2) often prevent the execution of complex 
orders that might otherwise be executable. Specifically, Rule 722(b)(2) 
provides that the legs of a complex order cannot be executed at the 
same price as a Priority Customer Order in the regular market unless 
another leg of the order is executed at a price that is better than the 
best price in the regular market.\7\ In other words, if there is a 
Priority Customer Order on the book in one or more of the series of a 
complex order, the net price of the complex order has to improve upon 
the price that would be available if the complex order legged-into the 
market. Thus, currently there can be complex orders resting on the book 
that cannot leg-into the market because the permissible ratio cannot be 
satisfied by the bids and offers in the regular market or because there 
are Priority Customer Orders in the regular market in one or more of 
the series of the complex order that prevent its execution. 
Accordingly, the Exchange believes that preventing orders with more 
than three legs (in some cases more than two legs) from legging-into 
the market does not create any unusual circumstances on the complex 
order book. The Exchange further notes that priority of complex orders 
on the complex order book is not impacted by the proposed rule 
change.\8\
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    \7\ Pursuant to ISE Rule 100(a)(37A) and (37B), a Priority 
Customer Order is an order for the account of a person or entity 
that (i) is not a broker or dealer in securities, and (ii) does not 
place more than 390 orders in listed options per day on average 
during a calendar month for its own beneficial account(s).
    \8\ For example, if there are multiple complex orders for the 
same strategy at the same price with four or more legs, they will be 
executed pursuant to Rule 722(b)(3) (i.e., in time priority or pro-
rata bases on size (with or without Priority Customer priority)).
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2. Statutory Basis
    The Exchange believes that its proposal is consistent with Section 
6(b) of the the [sic] Act\9\ in general, and furthers the objectives of 
Section 6(b)(5) of the Act\10\ 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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    \9\ 15 U.S.C. 78f(b).
    \10\ 15 U.S.C. 78f(b)(5).
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    The Exchange believes that requiring market makers to enter values 
into the risk parameters provided by the Exchange will not be 
unreasonably burdensome, as all ISE market makers currently utilize the 
functionality. Moreover, the Exchange is proposing this rule change at 
the request of its market makers to reduce their risk of inadvertently 
entering quotes without populating the risk parameters. As discussed 
above, the Exchange will be modifying the trading system to 
automatically reject quotations unless the parameters are populated 
with values, which will protect market makers from inadvertent exposure 
to excessive risk. Reducing such risk will enable market makers to 
enter quotations with larger size, which in turn will benefit investor 
through increased liquidity for the execution of their orders. Such 
increased liquidity benefits investors because they receive better 
prices and because it lowers volatility in the options market.
    The Exchange also believes it is reasonable to limit the types of 
complex orders that are eligible to leg-into the market. In this 
respect, the Exchange notes that the vast majority of complex orders 
consist of only two legs, which will be unaffected by this rule change. 
Moreover, the Exchange believes that the potential risk of continuing 
to offer legging functionality for complex orders with more than three 
legs (in some cases with more than two legs) limits the amount of 
liquidity that market makers are willing to provide in the regular 
market. In particular, market makers may reduce the size of their 
quotations in the regular market because they are at risk of executing 
the cumulative size of their quotations across multiple options series 
without an opportunity to adjust their quotes. Accordingly, reducing 
market maker risk in the regular market by limiting the legging 
functionality to orders with no more than three legs (in some cases 
with no more than two legs) will benefit investors by encouraging 
additional liquidity in the regular market. This benefit to investors 
far exceeds the small amount of potential liquidity provided by the few 
complex orders that have more than three legs (in some case more than 
two legs).

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

    The proposed rule change does not impose any burden on competition. 
The proposed rule change to make it mandatory for market makers to 
populate the quotation risk management parameters is being made at the 
request of ISE market makers to prevent the inadvertent entry of quotes 
without risk-management parameters. Market makers who prefer to use 
their own risk-management systems can enter out-of-range values so that 
the Exchange-provided parameters will not be triggered. Accordingly, 
the proposal does not require members to manage their risk using an 
Exchange-provided tool. The proposed change to limit legging 
functionality to complex orders of no more than three legs (in some 
cases no more than two legs) will reduce risk to market makers that are 
quoting in the regular market. As such, the proposal may encourage 
market makers to increase the size of their quotations, thereby adding 
liquidity on the Exchange.

[[Page 37873]]

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 publication date of this notice or within 
such longer period (1) as the Commission may designate up to 45 days of 
such date if it finds such longer period to be appropriate and 
publishes its reasons for so finding or (2) 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 Number SR-ISE-2013-38 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.

All submissions should refer to File Number SR-ISE-2013-38. 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 ISE. 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 Number SR-ISE-2013-38 and should be 
submitted on or before July 15, 2013.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-14962 Filed 6-21-13; 8:45 am]
BILLING CODE 8011-01-P


