
[Federal Register Volume 78, Number 156 (Tuesday, August 13, 2013)]
[Notices]
[Pages 49311-49313]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-19510]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-70132; File No. SR-ISE-2013-38]


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

August 7, 2013.

I. Introduction

    On June 5, 2013, the International Securities Exchange, LLC (the 
``Exchange'' or the ``ISE'') filed with the Securities and Exchange 
Commission (the ``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 related to market maker risk 
parameters and complex orders. The proposed rule change was published 
for comment in the Federal Register on June 24, 2013.\3\ The Commission 
received no comments on the proposal. This order approves the proposed 
rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 69782 (June 18, 
2013), 78 FR 37870 (June 24, 2013) (SR-ISE-2013-38) (the 
``Notice'').
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II. Description of the Proposal

    The Exchange proposes to amend ISE Rule 722 and ISE Rule 804 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 they enter quotes. These risk management 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 
may 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 
(4) 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.
    The Exchange notes that all ISE market makers currently use the 
risk management parameters when entering quotes but may inadvertently 
enter quotes without populating one or more of the parameters, and 
thereby be exposed to more financial risk than intended. The Exchange 
indicates that, in order to forestall such an occurrence, ISE market 
makers requested that the trading system be modified to reject a quote 
if a value for any of the four risk management parameters for the 
options class is missing. While entering values into the quotation risk 
parameters would be mandatory to prevent an inadvertent exposure to 
financial risk, the Exchange notes that market makers that prefer to 
use their own risk-management systems could simply enter values that 
assure the Exchange-provided parameters will not be triggered.\4\ 
Accordingly, the proposal requires that the fields for the quotation 
risk management parameters be populated, but does not require that 
members substantively or qualitatively 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 ISE Rule 722 to limit a market 
maker's financial risk exposure as it relates to the calculation of the 
aforementioned ISE Rule 804 risk parameters and complex orders legging-
into the regular market.\5\ Specifically, the Exchange

[[Page 49312]]

proposes to limit the legging functionality to complex orders with no 
more than either two or three legs, as determined by the Exchange on a 
class basis.\6\ In the Notice, the Exchange explains that because the 
execution of each leg of a complex order is contingent on the execution 
of the other legs and the execution of all the legs in the regular 
market is processed as a single transaction, not as a series of 
individual transactions, the legging-in of complex orders presents 
higher risk to market makers compared to regular orders being entered 
in multiple series of an options class in the regular market and may 
cause market makers to exceed the established risk parameters by a 
greater number of contracts. The Exchange also notes that because the 
potential to exceed the intended risk parameters 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 believes that because 85% of all complex orders have only two 
legs, and very few complex orders are entered with more than three 
legs, the potential risk to market makers in the regular market far 
out-weighs the potential benefit of offering such functionality to a 
very limited number of orders.
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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.
    \6\ The Exchange states that it 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 also states that it 
will provide members with reasonable notice prior to changing the 
limit applicable to an options class.
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    The Exchange also notes that 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 states that the execution priority 
rules contained in ISE Rule 722(b)(2) often prevent the execution of 
complex orders that might otherwise be executable because 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. The Exchange believes that 
preventing orders with more than three legs (in some cases more than 
two legs) from legging-into the market would not create any unusual 
circumstances on the complex order book. The Exchange also notes that 
the priority of complex orders on the complex order book will not be 
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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    In the Notice, the Exchange states that checking the risk 
management parameters following each execution in an options series 
allows market makers to provide liquidity across multiple series of an 
options class while mitigating the risk of executing the full 
cumulative size of all such quotes; however this is not the case when a 
complex order legs-into the market.

III. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities exchange.\9\ 
In particular, the Commission finds that the proposed rule change is 
consistent with Section 6(b)(5) of the Act,\10\ which requires, among 
other things, that the rules of a national securities exchange be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to remove impediments 
to and perfect the mechanism of a free and open market and a national 
market system, and, in general, to protect investors and the public 
interest; and are not designed to permit unfair discrimination between 
customers, issuers, brokers or dealers.
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    \9\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \10\ 15 U.S.C. 78f(b)(5).
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    The Commission believes the proposal is designed to provide market 
makers with a risk management tool to assist managing the financial 
exposure of market makers which in turn could enhance the integrity of 
trading on the securities markets and help to assure the stability of 
the financial system. The Commission believes that greater assurances 
related to the management of financial risk exposure could enable 
market makers to enter quotations with larger size, which in turn could 
benefit investors through increased liquidity for the execution of 
their orders, and that such increased liquidity could benefits 
investors by improving prices and lowering volatility in the options 
market.
    As discussed above, the proposed rule change is designed to protect 
market makers from exposure to inadvertent, excessive risk by modifying 
the trading system to automatically reject quotations unless values are 
entered for all four risk management parameters for all options classes 
in which quotes are entered. ISE asserts that all market makers 
currently utilize the Exchange provided risk management tool; and the 
catalyst for the instant proposal was a request from market makers that 
the entry of values into all four risk management parameters be made 
mandatory to avoid inadvertent error that could result in unintended 
financial exposure during quote entry. In addition, while market makers 
must populate the all risk management parameters in order to have their 
quotations accepted by the trading system, they may enter values in the 
parameters which effectively permit them to bypass the Exchange 
provided risk management tool in favor of a different, preferred risk 
management solution.
    In addition, the proposed rule change is designed to mitigate the 
financial risk associated with complex orders that leg-into the regular 
market. Specifically, the proposed rule change would limit the legging 
functionality to complex order with no more than two or three legs, as 
determined by the Exchange on a class basis. The Exchange represents 
that it will provide reasonable prior notice via a circular to members 
that identifies the applicable 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 notes that 85% 
of all complex orders only have two orders and very few complex orders 
have more than three legs, thus the vast majority of complex orders 
would be unaffected by this limitation. The Exchange also opined that 
market maker liquidity in the regular market may be limited as a result 
of the potential risk

[[Page 49313]]

of offering legging functionality for complex orders with more than 
three legs (in some cases with more than two legs). In particular, the 
Exchange notes that market makers may reduce the size of their 
quotations in the regular market because of the risk of executing the 
cumulative size of their quotations across multiple options series 
without an opportunity to adjust their quotes. Thus, the Exchange 
posits that limiting the legging functionality to orders with no more 
than three legs (in some cases with no more than two legs) could 
encourage market makers to add liquidity to the regular market which 
would in turn benefit investors.
    Accordingly, the Commission believes that the proposed rule change 
is consistent with Section 6(b)(5) of the Act.\11\
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    \11\ 15 U.S.C. 78f(b)(5)
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\12\ that the proposed rule change (SR-ISE-2013-38) is approved.
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    \12\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-19510 Filed 8-12-13; 8:45 am]
BILLING CODE 8011-01-P


