
[Federal Register Volume 79, Number 50 (Friday, March 14, 2014)]
[Notices]
[Pages 14563-14566]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-05592]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-71669; File No. SR-ISE-2014-10]


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

March 10, 2014.
    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 February 25, 2014, 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 and II below, which items have been prepared by 
the Exchange. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of the 
Substance of the Proposed Rule Change

    The Exchange proposes to amend its rules by limiting certain types 
of complex orders from legging 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 14564]]

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, the Proposed Rule Change

1. Purpose
    The Exchange currently provides functionality that automatically 
removes 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. 
Pursuant to Rules 722 and 804, these parameters are mandatory for 
market maker quotes. Market makers establish a time frame during which 
the system calculates: (1) The number of total 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 in an options class, and 
(b) calls sold plus puts purchased in an options class.\3\ Once the 
limits established by these parameters are triggered, the market 
maker's quotes are removed. 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.
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    \3\ See Securities Exchange Act Release No. 70132 (August 7, 
2013), 78 FR 49311 (August 13, 2013) (SR-ISE-2013-38).
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    Standard complex orders can contain up to eight (8) legs in the 
trading system today while complex orders with a stock component can 
contain up to eight (8) option legs and a stock leg. As discussed 
above, by checking the risk parameters following each execution in an 
options series, the risk parameters allow market makers to manage their 
risk. This is not the case, however, when a complex order legs into the 
regular 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. One market maker's quotes in the regular 
market can thus be hit in up to 8 instruments at the same time by a 
complex order.
    For example, if individual orders to buy 10 contracts for the Jan 
30 call, Jan 35 call and Jan 40 call 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. Thus, if the first, 
or second order trigger a market maker's risk setting, their quotes 
will be adjusted prior to the processing of the subsequent order. 
However, if a complex order to buy all three of these strikes with a 
quantity of 10 contracts 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 30 contracts (the sum of the three legs of 10 contracts each).
    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 can result in market 
makers exceeding their parameters by a greater number of contracts. At 
the request of market makers, the Exchange amended its rules to prevent 
complex orders from legging into the regular market if they have a 
large number of legs. Specifically, the Exchange currently limits the 
legging functionality to complex orders with no more than either two or 
three legs, as determined by the Exchange on a class by class basis.\4\ 
However, despite the current limitations, certain market participants 
continue to use atypical multi-leg strategies (2 or more legs) to trade 
with multiple quotes from a single market maker thereby causing the 
single leg market maker to trade far more than its limit allows. 
Although market makers can limit their risk by use of the Exchange's 
risk parameters, the market maker's quotes are not removed until after 
a trade is executed. As a result, because of the way complex orders leg 
into the regular market as a single transaction, market makers end up 
trading more than the limitations they have set and are therefore 
exposed to greater risk. In turn, market makers are forced to change 
their trading behavior to account for the additional risk by widening 
their quotes, hurting the Exchange's quality of markets and the quality 
of the markets in general available for trading.
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    \4\ Id.
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    At the request of members and to further minimize the impact to 
single leg market makers, the Exchange now proposes to amend Rule 722 
to limit a potential source of unintended market maker risk when 
certain types of complex orders leg into the regular market.\5\ 
Specifically, complex orders with two option legs where both legs are 
buying or both legs are selling and both legs are calls or both legs 
are puts will be executed only in the complex order book and will not 
be permitted to leg into the regular market. For example:
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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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[cir] Buy Call 1, Buy Call 2
[cir] Sell Call 1, Sell Call 2
[cir] Buy Put 1, Buy Put 2
[cir] Sell Put 1, Sell Put 2

    The Exchange also proposes a similar restriction to limit complex 
orders with three option legs, where all legs are buying or all legs 
are selling regardless of whether the option is a call or a put. For 
example:

[cir] Buy Call 1, Buy Call 2, Buy Put 1
[cir] Buy Put 1, Buy Put 2, Buy Put 3
[cir] Buy Call 1, Buy Call 2, Buy Call 3
[cir] Buy Put 1, Buy Put 2, Buy Call 3
[cir] Sell Put 1, Sell Put 2, Sell Call 1

    Strategies that involve these types of combinations of options are 
not traditional complex order strategies used by retail or professional 
investors, designed to gain exposure to a particular option class' 
movement. The vast majority of complex order strategies are made up of 
calendar and vertical spreads, butterflies and straddles, strategies 
that seek to hedge the potential move of the underlying security or to 
capture premium from an anticipated market event. In contrast, the 
atypical strategies illustrated above are primarily geared towards an 
aggressive directional capture of volatility. Through a combination of 
buying or selling multiple option legs at once, regardless of the 
implied directional move represented by a call versus a put, a market 
participant using one of these strategies is aggressively buying or 
selling volatility. By using the complex order mechanism that allows 
for the simultaneous executions of all legs, these strategies aim to 
bypass a single leg market maker's risk settings and result in an 
artificially large transaction that distorts the market for other 
related instruments, including the underlying security. These 
distortions in the market for the underlying security and related 
option series are caused by the simultaneous hedging activity triggered 
by such strategies. By legging in and potentially bypassing the risk 
settings of several market participants, these strategies create a 
larger trade than otherwise possible through the use of `simple' or 
single-leg orders which then results in the affected market 
participants needing to immediately hedge these outsized positions. 
This activity in turn causes an immediate

[[Page 14565]]

distortion in the market of the related securities as these market 
participants attempt to simultaneously buy or sell the underlying 
security or related option series. This type of effect can also be a 
result of a simple, large order affecting several liquidity providers, 
but in the case of a complex strategy, involving several legs and 
therefore more size, the impact is more pronounced. By limiting these 
types of complex orders from legging in, the Exchange will strengthen 
the effectiveness of the risk tools it provides and thereby allow 
liquidity providers to post tighter and more liquid markets for regular 
orders and traditional complex orders, while at the same time reducing 
the frequency and size of related market distortions.
    Further, the Exchange currently offers an order type called 
``legging orders'' \6\ to provide additional liquidity for complex 
orders resting on the complex order book. A complex order resting on 
the complex order book may be executed either by: (i) Trading against 
an incoming complex order that is marketable against the resting 
complex order, or (ii) trading in the regular market when the net price 
of the complex order can be satisfied by executing all of the legs 
against the best bids or offers on the Exchange for the individual 
options series. Under current rules, legging orders may be generated 
automatically for simple two-legged options orders with the same 
quantity on both legs. However, with this proposed rule change, which 
in part applies to simple two-legged options orders with the same 
quantity on both legs, legging orders cannot be executed for these 
complex orders due the manner in which the trading system is designed. 
Specifically, the same component in the trading system handles both the 
trading of complex orders in the regular market and the execution of 
legging orders. Therefore, the proposed limitation to exclude these 
complex orders from trading in the regular market also means that the 
trading system will not generate legging orders for these types of two-
legged complex orders. The Exchange proposes to adopt language in 
proposed Rule 722(b)(3)(ii)(A) to note that the trading system will not 
generate legging orders for these complex orders.\7\
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    \6\ A legging order is a limit order on the regular limit order 
book that represents one side of a complex order that is to buy or 
sell an equal quantity of two options series resting on the 
Exchange's complex order book. See ISE Rule 715(k).
    \7\ The Exchange is not proposing to adopt similar language in 
proposed Rule 722(b)(3)(ii)(B) because legging orders cannot be 
generated for complex orders with 3 option legs.
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    Additionally, the Exchange's Facilitation Mechanism has been 
available for the execution of complex orders since 2005 \8\ and the 
Solicited Order Mechanism has been available for the execution of 
complex orders since 2006.\9\ And since 2011, members have also been 
able to execute complex orders in the Price Improvement Mechanism.\10\ 
All three mechanisms expose orders to all Exchange members for 500 
milliseconds to provide an opportunity for price improvement. Complex 
orders are processed in these mechanisms at a net price in the same 
manner as single-legged orders. If an improved net price for a complex 
order being executed can be achieved from bids and offers for the 
individual legs of the complex order in the Exchange's auction market, 
the order being executed receives an execution at the better net price. 
A single component in the trading system component handles both the 
trading of a new complex order with the regular order book upon arrival 
and at the end of the 500 millisecond exposure period. For complex 
orders that are the subject of this proposed rule change, if an 
improved net price for such complex orders being executed can be 
achieved from bids and offers for the individual legs of the complex 
order, the auction order cannot trade with the individual legs. Because 
an auction order, such as a PIM or a Facilitation cannot trade outside 
the ISE's best bid or offer, the auction order will be cancelled at the 
end of the 500 millisecond exposure period. The cancellation of auction 
orders in such instances is similar to the current handling of 
situations when the bid or offer at the ISE, made up of individual 
series, becomes better than the net price of the complex auction order 
on the same side (bid better during an auction order where the agency 
side is the buyer, ask better during an auction where the agency side 
is the seller). In these instances, at the end of the 500 millisecond 
exposure period, if the net price of the auction order is inferior to 
the bid or offer on the same side of auction order, the auction is 
cancelled without any execution. With respect to the bids and offers 
for the individual legs of a complex order entered into the three 
mechanisms, the priority rules for complex orders contained in Rule 
722(b)(2) will continue to apply.
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    \8\ See Securities Exchange Act Release No. 52327 (August 24, 
2005), 70 FR 51854 (August 31, 2005) (SR-ISE-2004-33).
    \9\ See Securities Exchange Act Release No. 53729 (April 26, 
2006), 71 FR 26154 (May 3, 2006) (SR-ISE-2006-15).
    \10\ See Securities Exchange Act Release No. 64805 (July 5, 
2011), 76 FR 40758 (July 11, 2011) (SR-ISE-2011-30).
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    The Exchange proposes to amend Supplementary Material .08 to Rule 
716 and Supplementary Material .10 to Rule 723 to reflect how complex 
orders listed in proposed Rule 722(b)(3)(ii)(A) and (B) are treated in 
the Exchange's three auction mechanisms.
    The Exchange notes that the number of these atypical complex orders 
is small relative to the total number of complex orders executed on the 
Exchange on a given day. The Exchange believes that the potential risk 
to market makers in the regular market of allowing these atypical 
complex orders out-weighs the potential benefit of offering such 
functionality to a very limited number of orders. With this proposal, 
the Exchange is not entirely restricting the execution of these types 
of complex orders. These orders may still be executed in the complex 
order book thus, will rest on the complex order book until they are 
traded or cancelled by the member that entered them.
2. Statutory Basis
    The Exchange believes that its proposal is consistent with Section 
6(b) of the Securities Exchange Act of 1934 (the ``Act'') \11\ in 
general, and furthers the objectives of Section 6(b)(5) of the Act \12\ 
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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    \11\ 15 U.S.C. 78f(b).
    \12\ 15 U.S.C. 78f(b)(5).
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    The Exchange believes it is reasonable to limit the types of 
complex orders that are eligible to leg-into the regular market. In 
this respect, the Exchange notes that the vast majority of complex 
orders sent to the Exchange will be unaffected by this rule change. 
Moreover, the Exchange believes that the potential risk of continuing 
to offer legging functionality for complex orders such as those 
impacted by the proposed rule change 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 as 
proposed herein will benefit investors by encouraging additional 
liquidity in

[[Page 14566]]

the regular market. This benefit to investors far exceeds the small 
amount of potential liquidity provided by the few complex orders this 
proposal seeks to restrict to trading in the complex order book.

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

    The proposed rule change does not impose any burden on competition. 
The proposed change to limit legging functionality, as proposed, 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.

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

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

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

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

IV. Solicitation of Comments

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

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-ISE-2014-10 on the subject line.

Paper Comments

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

All submissions should refer to File Number SR-ISE-2014-10. 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 offices of the Exchange. 
All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-ISE-2014-10, 
and should be submitted on or before April 4, 2014.

    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. 2014-05592 Filed 3-13-14; 8:45 am]
BILLING CODE 8011-01-P


