
[Federal Register Volume 79, Number 178 (Monday, September 15, 2014)]
[Notices]
[Pages 55033-55036]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-21869]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-73023; File No. SR-ISE-2014-10]


Self-Regulatory Organizations; International Securities Exchange, 
LLC; Order Approving a Proposed Rule Change Related To Limiting Certain 
Types of Complex Orders From Legging Into the Regular Market

September 9, 2014.

I. Introduction

    On February 25, 2014, the International Securities Exchange, LLC 
(the ``Exchange'' or ``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 relating to complex orders. The 
proposed rule change was published for comment in the Federal Register 
on March 14, 2014.\3\ On April 23, 2014, the Commission extended the 
time period in which to either approve the proposal, disapprove the 
proposal, or to institute proceedings to determine whether to approve 
or disapprove the proposal, to June 12, 2014.\4\ On June 10, 2014, the 
Commission instituted proceedings to determine whether to approve or 
disapprove the proposed rule change.\5\ The Commission received five 
comment letters on proposal.\6\ 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. 71669 (March 10, 
2014), 79 FR 14563 (``Notice'').
    \4\ See Securities Exchange Act Release No. 72006 (April 23, 
2014), 79 FR 24031 (April 29, 2014).
    \5\ See Securities Exchange Act Release No. 72359 (June 10, 
2014), 79 FR 34387 (June 16, 2014).
    \6\ See letters to Elizabeth Murphy, Secretary, Commission, from 
Kurt Eckert, Principal, Wolverine Trading, LLC, dated July 7, 2014 
(``Wolverine Letter''); Ellen Green, Vice President, Financial 
Services Operations, Securities Industry and Financial Markets 
Association, dated July 8, 2014 (``SIFMA Letter''); Wouter Stinis, 
Head of Trading, Optiver US, LLC, dated July 9, 2014 (``Optiver 
Letter''); letter to Kevin M O'Neill, Deputy Secretary, Commission, 
from John Kinahan, Interim-CEO, Group One Trading, L.P., dated July, 
7, 2014 (``Group One Letter''); letter to the Office of the 
Secretary, Commission, from Martha Redding, Chief Counsel and 
Assistant Corporate Secretary, NYSE, Inc. dated July 10, 2014 
(``NYSE Letter'').
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II. Description of the Proposal

    The Exchange proposes to amend ISE Rule 722 to prohibit certain 
types of complex orders from legging into the regular market (i.e., 
executing against individual quotes for each of the legs of the complex 
order in the regular market).\7\ Specifically, ISE proposes that 
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 
only trade against other complex orders in the complex order book and 
will not be permitted to leg into the regular market.\8\ ISE also 
proposes that complex orders with three option legs where all legs are 
buying or all legs are selling, regardless of whether the options are a 
calls or puts, will only trade against other complex orders in the 
complex order book and will not be permitted to leg into the regular 
market.\9\ ISE describes these types of two and three leg complex order 
strategies as ``atypical'' complex order strategies in that they are 
geared toward an aggressive directional capture of volatility.\10\
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    \7\ See Notice, supra note 3, at 14564. ISE Rule 722(b)(3)(ii) 
rule states that complex orders up to a maximum number of legs 
(determined by the Exchange on a class basis as either two legs or 
three legs) will be automatically 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.
    \8\ See Notice, supra note 3, at 14564. The Exchange offers some 
examples of such strategies as follows: (i) Buy Call 1, Buy Call 2; 
(ii) Sell Call 1, Sell Call 2; (iii) Buy Put 1, Buy Put 2; (iv) Sell 
Put 1, Sell Put 2. See id.
    \9\ See id. The Exchange offers some examples of such strategies 
as follows: (i) Buy Call 1, Buy Call 2, Buy Put 1; (ii) Buy Put 1, 
Buy Put 2, Buy Put 3; (iii) Buy Call 1, Buy Call 2, Buy Call 3; (iv) 
Buy Put 1, Buy Put 2, Buy Call 3; (v) Sell Put 1, Sell Put 2, Sell 
Call 1. See id.
    \10\ See id. Hereinafter these two and three legged complex 
order strategies that are the subject of this proposal will be 
referred to as ``directional complex orders.'' ISE states that most 
traditional complex order strategies used by retail or professional 
investors, unlike directional complex orders, seek to hedge the 
potential move of the underlying security or to capture a premium 
from an anticipated market event. See id.
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    The Exchange further proposes to amend ISE Rule 722 to prevent 
legging orders \11\ from being generated on behalf of the two-legged 
complex orders where

[[Page 55034]]

both legs are buying or both legs are selling and both legs are calls 
or both legs are puts.\12\ According to the Exchange, preventing the 
generation of legging orders for these types of two-legged complex 
orders is necessary to effectuate the proposed limitation to exclude 
these types of complex orders from trading in the regular market.\13\
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    \11\ ISE Rule 715(k) defines a legging order as 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.
    \12\ See Notice, supra note 3, at 14565. The Exchange notes that 
legging orders cannot be generated for complex orders with three 
options legs, and, therefore, is not proposing to prevent the 
generation of legging orders for complex orders with three option 
legs where all legs are buying or all legs are selling, regardless 
of whether the options are calls or puts. See id.
    \13\ See id.
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    In addition, the Exchange proposes to amend Supplemental Material 
.08 to ISE Rule 716 (Facilitation Mechanism and Solicited Order 
Mechanism) and Supplemental Material .10 to ISE Rule 723 (Price 
Improvement Mechanism) to ensure that directional complex orders do not 
leg into the regular market through an auction.\14\ ISE represents 
that, under its current rules, if an improved net price for a complex 
order in the Exchange's auctions can be achieved from bids and offers 
for the individual legs of the complex order in the regular market, the 
complex order would receive that better net price.\15\ ISE proposes to 
prevent directional complex orders from interacting with the regular 
market during an auction in connection with the Exchange's proposal in 
order to prevent directional complex orders from executing against the 
regular market.\16\ Accordingly, the Exchange proposes to amend 
Supplemental Material .08 to ISE Rule 716 and Supplemental Material .10 
to ISE Rule 723 to provide that if an improved net price can be 
achieved from bids and offers for the individual legs for directional 
complex orders during an auction, ISE will cancel the auction at the 
end of the auction's exposure period.\17\
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    \14\ See id.
    \15\ See id.
    \16\ See Notice, supra note 3, at 14565.
    \17\ See id.
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    According to the Exchange, the proposed rule amendments are 
designed to prevent directional complex orders from bypassing the 
Exchange's market maker risk parameters for the regular market.\18\ ISE 
states that the market maker risk parameters are designed to 
automatically remove a market maker's quotes in all series of an 
options class when any of four parameter settings established by the 
market maker are triggered.\19\ ISE describes these market maker risk 
parameters as a functionality that allows market makers to provide 
liquidity across many different options series without being at risk of 
executing the full cumulative size of all of their quotes before being 
given adequate opportunity to adjust their quotes.\20\ According to 
ISE, when a complex order legs into the regular market, all of the legs 
of a complex order are considered as a single transaction for purposes 
of the market maker risk parameters, and not as a series of individual 
transactions.\21\ Thus, the trading system performs the market maker 
risk parameter calculations after the entire complex order executes 
against interest in the regular market. According to the Exchange, the 
manner in which complex orders leg into the regular market may cause 
market makers to trade above limits set in their market maker risk 
parameters.\22\ As a result, the Exchange believes that market makers 
may alter their trading behavior to account for the additional risk by 
widening quotes, hurting the Exchange's quality of markets and the 
quality of markets in general.\23\ Further, according to ISE, 
directional complex orders that bypass market makers' risk parameters 
may result in artificially large transactions that distort the market 
for related instruments, including the underlying security or related 
options series.\24\ The Exchange believes that the potential risk to 
market makers of allowing directional complex orders to execute against 
market makers' quotes in the regular market outweighs the potential 
benefit of allowing directional complex orders to execute against 
interest in the regular market.\25\ By limiting directional complex 
orders from legging into the regular market, the Exchange believes that 
market makers will post tighter and more liquid markets for regular 
orders and traditional complex orders, while reducing the frequency and 
size of related market distortions.\26\
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    \18\ See id. at 14564 and ISE Rule 804(g) (Automated Quotation 
Adjustments). See also Supplemental Material .04 to ISE Rule 722 
(Automated Spread Quotation Adjustments).
    \19\ See Notice, supra note 3, at 14564.
    \20\ See id.
    \21\ See id.
    \22\ See id.
    \23\ See id.
    \24\ See id.
    \25\ See Notice, supra note 3, at 14565. ISE notes that the 
number of directional complex orders is small relative to the total 
number of complex orders executed on the Exchange on a given day. 
See id.
    \26\ See id.
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    Finally, ISE represents that directional complex orders may trade 
against other complex orders in the ISE complex order book and may rest 
on the ISE complex order book until they are traded or canceled by the 
member that entered them.\27\
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    \27\ See id.
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III. Summary of Comment Letters

    As previously noted, the Commission received five comment 
letters.\28\ All of the commenters support the proposal and believe the 
Commission should approve it.
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    \28\ See supra note 6.
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    Several commenters state that they rely on market maker risk 
parameter mechanisms to prevent them from exceeding a set amount of 
risk without having the opportunity to update the price or size of 
their quotes to better reflect the state of the current market.\29\ One 
commenter, a national securities exchange, states that market makers 
and other participants who contribute to price discovery by posting 
displayed bids and offers incur significant risk of taking on large 
options positions on the same side of the market, potentially causing a 
liquidity provider to accumulate unacceptable risk levels very 
quickly.\30\ This commenter states that, because of this, options 
exchanges make available to their market makers and other market 
participants risk protection tools that restrict the amount of risk a 
liquidity provider can accumulate per unit time before their quotes or 
orders are disabled.\31\ Another commenter, a market maker, states that 
it relies on the exchange-level market maker risk parameter mechanisms 
to ensure that its quotes are removed from the market when its risk 
tolerance is exceeded.\32\ According to this commenter, it is because 
of these market maker risk parameters that market makers are able to 
quote tight spreads and deep liquidity.\33\
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    \29\ See e.g., Group One Letter, supra note 6, at 1; Wolverine 
Letter, supra note 6, at 1.
    \30\ See NYSE Letter, supra note 6, at 1.
    \31\ See id.
    \32\ See Group One Letter, supra note 6, at 1. See also 
Wolverine Letter, supra note 6, at 1 (stating that market makers are 
reliant on exchange-level market maker risk parameters mechanisms to 
protect market makers from assuming undue risk if multiple resting 
quotes are executed in rapid succession).
    \33\ See Group One Letter, supra note 6, at 1. See also 
Wolverine Letter, supra note 6, at 1 (stating that market makers are 
able to provide tight, deep, competitive markets based on the 
understanding that they can, to a reasonable degree, control the 
amount of risk they assume within a single trade or sequence of 
trades before being able to recalculate and republish their quotes).
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    Commenters generally agree that directional complex orders allow 
market participants to circumvent a market-maker's risk parameters.\34\ 
Several

[[Page 55035]]

commenters assert that directional complex orders are not traditional 
complex orders used by retail and professional investors.\35\ One 
commenter notes that, while any complex order, traditional or 
directional, legging into the market could circumvent a market-maker's 
risk parameters, such circumvention is justifiable for traditional 
complex orders but not directional complex orders.\36\ This commenter 
explains that traditional complex orders, such as spreads or straddles, 
are designed to provide some degree of directional protection, where 
gains in one leg may be at least partially offset by losses in another, 
which, according to the commenter, renders the risk of these 
traditional complex orders executing as a single transaction more 
tolerable.\37\ However, according to this commenter, directional 
complex orders often increase the net directional exposure because they 
consist of all bullish or bearish positions where no one leg hedges any 
other, as is the case for traditional complex orders.\38\
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    \34\ See Wolverine Letter, supra note 6, at 2; Optiver Letter, 
supra note 6, at 2; Group One Letter, supra note 6, at 1; NYSE 
Letter, supra note 6, at 2; and SIFMA Letter, supra note 6, at 3.
    \35\ See e.g., Wolverine Letter, supra note 6, at 2; Optiver 
Letter, supra note 6, at 1-2; and Group One Letter, supra note 6, at 
2.
    \36\ See Wolverine Letter, supra note 6, at 1-2. See also NYSE 
Letter, supra note 6, at 2.
    \37\ See Wolverine Letter, supra note 6, at 1.
    \38\ See Wolverine Letter, supra note 6, at 2. See also NYSE 
Letter, supra note 6, at 2 (noting that most complex orders ``. . . 
are `self-hedged,' i.e., comprising one or more `long' sides offset 
by one or more `short' sides'').
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    Generally, all of the commenters agree that directional complex 
orders restrict market-makers' ability to mitigate their risk and, in 
turn, their ability to quote in larger sizes with tighter spreads 
across many different options series.\39\ One commenter states that 
without the protection offered by the market maker risk parameters, its 
only remaining controls at its disposal to protect against the risk of 
directional complex orders are to widen quoted spreads and/or reduce 
the size of its quotes in the single leg market.\40\ This commenter 
also notes that it may even cancel all its quotes in related 
instruments on other exchanges where the commenter provides liquidity 
in response to an execution of a directional complex order against its 
quotes, or may even stop quoting altogether on venues where directional 
complex orders are permitted to circumvent a market maker's risk 
parameters.\41\ One commenter states that these directional complex 
orders may force market makers to hedge their position more urgently 
than for other transactions, which hedging may cause a larger, 
temporary, market impact in the underlying securities than normal 
hedging activity does.\42\ One commenter states that it would be able 
to provide larger published quotes and/or tighter spreads if the 
proposal is approved.\43\
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    \39\ See Wolverine Letter, supra note 6, at 2; Optiver Letter, 
supra note 6, at 4; Group One Letter, supra note 6, at 1-2; NYSE 
Letter, supra note 6, at 1-2; and SIFMA Letter, supra note 6, at 4-
5.
    \40\ See Optiver Letter, supra note 6, at 3.
    \41\ See Optiver Letter, supra note 6, at 3-4.
    \42\ See SIFMA Letter, supra note 6, at 4. This commenter also 
notes that retail investors' limit orders may also be adversely 
impacted by directional complex orders because such orders can 
result in large price swings, which may result in stop orders being 
triggered. Id.
    \43\ See Wolverine Letter, supra note 6, at 2. See also Group 
One letter, supra note 6, at 2 (noting that by allowing market 
makers to rely on the Exchange's market maker risk parameters, 
``market makers can continue to provide large size quotes with tight 
spreads''); and Optiver Letter, supra note 6, at 5 (asserting that 
approval would ``further allow tighter markets and increased 
liquidity for both complex orders and the regular market'').
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    Two commenters state that they believe that the number of 
directional complex orders is small relative to the total number of 
complex orders executed on the Exchange in a given day.\44\ Some 
commenters note that most directional complex orders come from market 
makers.\45\ One commenter states that, according to one market 
participant, 95% of directional complex orders that executed against 
that participant's quotes over the last year originated from the market 
making desk of one firm.\46\ According to this commenter, of the 
complex order flow received by that same market participant from 
institutional and retail customers over the past year, zero directional 
complex orders came from institutional customers and just 0.1% of 
retail complex orders were directional.\47\ Another commenter notes 
that the average trade number of contracts executed in traditional 
complex orders against the commenter's quotes in 2014 was 14.8 
contracts per trade, which is, according to the commenter, generally 
consistent with the Options Clearing Corporation's data indicating an 
average number of contracts per average transaction of 15.6 contracts 
on the Exchange.\48\ The commenter then notes that the average number 
of contracts per transaction against the commenter's quotes for 
directional complex orders was 157.3 contracts.\49\
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    \44\ See SIFMA Letter, supra note 6, at 5; Optiver Letter, supra 
note 6, at 4 (noting that it believes 3-legged directional complex 
orders represents less than 1% of total orders).
    \45\ See SIFMA Letter, supra note 6, at 3; Optiver Letter, supra 
note 6, at 2 (noting that, in the commenter's experience, ``these 
[directional] order types are overwhelmingly used by market 
makers'').
    \46\ See SIFMA Letter, supra note 6, at 3.
    \47\ See id. Two commenters state that they believe that the 
number of directional complex orders is small relative to the total 
number of complex orders executed on the Exchange in a given day.
    \48\ See Optiver Letter, supra note 6, at 3.
    \49\ See id.
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    Two commenters state that they believe that the potential benefits 
of preventing directional complex orders from legging into the regular 
market under the Exchange's proposal outweighs any benefits of 
continuing to allow directional complex orders to leg into the regular 
market.\50\ One commenter asserts that market maker risk protections in 
the regular market must have priority over directional complex orders 
that leg into that same regular market.\51\ Another commenter states 
that it believes that approval of the proposal will deter potentially 
nefarious activity without reducing liquidity for regular orders or 
traditional complex orders.\52\
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    \50\ See SIFMA Letter, supra note 6, at 5; Optiver Letter, supra 
note 6, at 5.
    \51\ See Optiver Letter, supra note 6, at 5.
    \52\ See Group One Letter, supra note 6, at 2. Two commenters 
also express support for the part of the Exchange's proposal that 
would require that an auction be canceled at the end of the 
auction's exposure period if an improved net price can be achieved 
from the bids and offers for the individual legs of a directional 
complex order during an auction. See SIFMA Letter, supra note 6, at 
3; Optiver Letter, supra note 6, at 2.
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IV. Discussion and Commission Findings

    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.\53\ In particular, the Commission finds that the proposed 
rule change is consistent with Section 6(b)(5) of the Act,\54\ 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. The Commission notes that directional complex orders 
may continue to trade against other complex orders on the Exchange's 
complex order book, and that market participants may submit the 
individual legs of a directional complex order separately to the 
regular market for execution should they so choose. The Commission also 
notes that all five

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commenters expressed support for the proposal.
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    \53\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 78c(f).
    \54\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\55\ that the proposed rule change (SR-ISE-2014-10) is approved.
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    \55\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\56\
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    \56\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-21869 Filed 9-12-14; 8:45 am]
BILLING CODE 8011-01-P


