Self-Regulatory Organizations; The Pacific Exchange, Inc.; Order Approving Proposed Rule Change To Allow Staffing of the Public Limit Order Book by Employees of the LMM

[Federal Register Volume 64, Number 134 (Wednesday, July 14, 1999)]
[Notices]
[Pages 38064-38066]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-17885]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41595; File No. SR-PCX-98-02]


Self-Regulatory Organizations; The Pacific Exchange, Inc.; Order 
Approving Proposed Rule Change To Allow Staffing of the Public Limit 
Order Book by Employees of the LMM

July 2, 1999.

I. Introduction

    On January 23, 1998, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC''), 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 expand its Lead Market Maker 
(``LMM'') Book Program (``Program'') to allow qualified LMMs to manage 
their own employees in operating the options public limit order book 
(``Book''). The proposed rule change was published for comments \3\ in 
the Federal Register on April 22, 1998.\4\ The Commission received no 
comments on the proposal. This order approves the proposed rule 
change.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On April 13, 1998, the PCX submitted a letter, in response 
to Commission staff questions, providing a brief explanation of its 
proposed method for admitting employees to participate in the LMM 
Program and concerning its proposed surveillance of the LMM Program 
employees and operations. The substance of this letter is 
incorporated into this order. See Letter from Michael D. Pierson, 
Senior Attorney, Regulatory Policy, PCX, to Marie D'Aguanno Ito, 
Special Counsel, Division of Market Regulation (``Division''), 
Commission, dated April 13, 1998 (``PCX Letter No. 1'').
    \4\ Securities Exchange Act Release No. 39875 (April 15, 1998), 
63 FR 19994.
    \5\ On March 15, 1999, the PCX submitted a letter further 
explaining the supervision and training of LMM-employed Order Book 
Officials. The letter also clarifies that for purposes of the 
proposed rule change LMMs operating the Book will assume the duties 
and liabilities of the Exchange. The substance of this letter is 
incorporated into this order. See letter from Robert P. Pacileo, 
Staff Attorney, Regulatory Policy, PCX, to Richard Strasser, 
Assistant Director, Division, Commission, dated February 10, 1999 
(``PCX Letter No. 2'').
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II. Description of the Proposal

    On October 11, 1996, the Commission approved an Exchange proposal 
to adopt a one-year pilot program under which a limited number of LMMs 
would be able to assume operational responsibility for the options 
public limit order book in certain option issues.\6\ Initially, the 
Program's participation was limited to three LMMs and 40 option 
symbols.\7\ On April 1, 1997, the Commission approved an Exchange 
proposal to expand the Program limits to nine LMMs and 150 option 
symbols.\8\ On September 22, 1997, the Commission approved an Exchange 
proposal to extend the pilot program for an additional year.\9\ 
Subsequently, the Commission approved an Exchange proposal to make the 
Program permanent.\10\
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    \6\ See Exchange Act Release No. 37810 (October 11, 1996), 61 FR 
54481 (October 18, 1996) (approving File No. SR-PSE-96-09).
    \7\ Id.
    \8\ See Exchange Act Release No. 38462 (April 1, 1997), 62 FR 
16886 (April 8, 1997).
    \9\ See Exchange Act Release No. 39106 (September 22, 1997), 62 
FR 51172 (September 30, 1997).
    \10\ See Exchange Act Release No. 40548 (October 14, 1998), 63 
FR 56283 (October 21, 1998).
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    Under the Program,\11\ approved LMMs may manage the Book function 
with the assistance of Exchange personnel, take responsibility for 
trading disputes and errors, set rates for Book execution, and pay the 
Exchange a fee for systems and services.\12\ Presently, an LMM must be 
certified as qualified by the Exchange's Options Floor Trading 
Committee (``OFTC'') before an employee of that LMM may assist with 
Book operation. Certification of an LMM is based on some or all of the 
following factors: experience with trading an options issue as a market 
maker or LMM and willingness to assume LMM responsibilities; trading 
volume of the options issue(s); adequacy of capital; willingness to 
promote the Exchange as a marketplace; history of adherence to Exchange 
rules and securities laws; trading crowd/LMM evaluations conducted 
pursuant to Options Floor Procedure Advice B-13; and ability to manage 
the Book operation.\13\
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    \11\ Only multiple-listed option issues are currently eligible 
to be traded unde the Program. See Exchange Act Release No. 38273 
(February 12, 1997), 62 FR 7489 (February 19, 1997).
    \12\ See Exchange Act Release No. 37874 (October 28, 1996), 61 
FR 56597 (November 1, 1996) (approving SR-PSE-96-38, establishing a 
staffing charge for LMMs who participate in the pilot program).
    \13\ See Exchange Act Release No. 37810, note 6, supra.
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    The Exchange now proposes to expand the Program to allow qualified 
LMMs to manage their own employees in operating the Book. Currently, 
the Exchange required participating LMMs to use Exchange personnel to 
assist the LMM in performing the Order Book Official (``OBO'') 
function, for which the Exchange charges the LMM a staffing charge.\14\ 
LMMs who opt to manage their own employees in the Book operation would 
continue to set their own rates for Book executions, and would only be 
required to use Exchange staff, and pay a staffing charge, under

[[Page 38065]]

unusual circumstances.\15\ If an LMM is not currently participating in 
the Program and wished to use its own employees to staff the Book, that 
LMM would apply to the OFTC for approval. An LMM currently 
participating in the Program wishing to begin using its own employees 
to staff the Book would also need to apply to the OFTC for approval.
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    \14\ Id. Also see PCX Rule 6.82(h)(1)(a).
    \15\ In the event of unusual market circumstances, the Exchange 
will make Exchange staff available to assist the LMMs in performing 
their CBO functions on a temporary basis, and will charge such LMMs 
a reasonable fee for such services. The Exchange intends to file 
with the Commission a proposed rule change to establish temporary 
staffing charges for LMMs.
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    Under the proposal, employees of qualified LMMs operating the Book 
will be required to perform OBO functions, pursuant to PCX Rules 6.51 
through 6.59, as if they were Exchange employees. Like OBOs who are 
Exchange employees, the LMM staff handling the OBO functions will have 
the duty to: (1) Assist in the maintenance of a fair, orderly and 
competitive market; \16\ (2) report any unusual activity, transactions 
or price changes or other unusual market conditions or circumstances 
that are detrimental to the maintenance of a fair, orderly and 
competitive market to an Options Floor Official; \17\ and (3) disclose 
to members, upon request, the price and number of contracts that are 
bid below or that are offered above the Book information displayed.\18\ 
The Exchange has represented that the LMM employees who will most 
likely operate the Book initially will be former Exchange OBOs and LMM 
employees who presently work with Exchange OBOs in apprentice-like 
fashion.\19\ For the purposes of this proposal, LMMs will assume the 
liabilities of the Exchange under PCX Rules 6.59(a) and 13 for any 
loss, expense, damage or claim arising out of errors or omissions of 
their Book staff.\20\
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    \16\ See PCX Rule 6.53.
    \17\ See PCX Rule 6.54.
    \18\ See PCX Rules 6.55 and 6.57.
    \19\ See PCX Letter No. 2, note 5, supra.
    \20\ Id.
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    The Exchange believes that allowing LMMs to use their own employees 
to operate the Book will have no negative impact on the Exchange's 
oversight and regulation of activities on the Options Trading Floor. 
LMMs who operate the Book will continue to be subject to higher capital 
requirements than other LMMs or Market Makers.\21\ The Exchange will 
continue to employ Exchange staff to monitor the operations of all 
LMMs.\22\ Exchange staff will also continue to prepare all Unusual 
Activity Reports that are forwarded to the Surveillance Department for 
review and to monitor the activities of LMMs, including those 
activities that are brought to the attention of Floor Officials by 
members of the trading crowd.\23\ Finally, in addition to the on-site 
monitoring, Exchange staff will also use automated reports for the LMM 
Limit Order Book and Opening Price Surveillance to help ensure that the 
LMM is meeting its duties regarding the Book.\24\
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    \21\ See PCX Rule 6.82, Commentary .05 (requiring LMMs who run 
the Book to maintain ``minimum net capital,'' as provided in 
Exchange Act Rule 15c3-1, and also to maintain a cash or liquid 
asset position of at least $500,000, plus $25,000 for each issue 
over 5 issues for which they perform the function of an OBO).
    \22\ See PCX Letter No. 2, note 5, supra.
    \23\ Id.
    \24\ Id.
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III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the Act \25\ and, in particular, with Section 6(b) of the Act.\26\ 
Specifically, the Commission finds that the proposal is consistent with 
the Section 6(b)(5) \27\ requirements that the rules of an exchange be 
designed to promote just and equitable principles of trade, to prevent 
fraudulent and manipulative acts and practices, and, in general, to 
protect investors and the public interest.
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    \25\ In approving this rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \26\ 15 U.S.C. 78f(b).
    \27\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that the proposal is reasonably designed to 
maintain, without disruption to activities on the Exchange's Options 
Trading Floor, the effective operation of the Book. Under the proposal, 
LMMs must be certified as Program qualified by the Exchange's OFTC 
based on a number of factors, including the LMM's ability to manage the 
Book operation. Additionally, the employees of qualified LMMs operating 
the Book will be required to perform OBO functions, pursuant to PCX 
Rules 6.51 through 6.59, as if they were Exchange employees. Like OBOs 
who are Exchange employees, the LMM staff handling the OBO functions 
will have the duty to, amongst other things: (1) Assist in the 
maintenance of a fair, orderly and competitive market; and (2) report 
any unusual activity, transactions or price changes or other unusual 
market conditions or circumstances that are detrimental to the 
maintenance of a fair, orderly and competitive market to an Options 
Floor Official. The LMM will be responsible for the proper execution of 
OBO functions by their employees, and for the purposes of this 
proposal, the LMMs will assume the liabilities of the Exchange under 
PCX Rules 6.59(a) and 13 for any loss, expense, damage or claim arising 
out of errors or omissions of their Book staff. Thus, all the OBO 
functions that are currently administered by Exchange employees should 
continue to be executed by LMM employees under the proposal.
    The Commission also believes that the Exchange's proposal is 
reasonably designed to provide LMM-employed OBOs with adequate 
supervision. The Exchange has represented that LMMs who operate the 
Book will be subject to heightened scrutiny as compared to LMMs who do 
not operate the Book. The Exchange also represents that Floor Officials 
will continue to supervise the LMM trading crowds to which they are 
assigned. As a result, members seeking information or wishing to file a 
complaint may go to a Floor Official or Exchange Floor managers. 
Additionally, LMMs who undertake the operation of the Book under the 
proposal will continue to be subject to higher capital requirements 
than other LMMs or Market Makers; Exchange staff will continue to 
prepare all Unusual Activity Reports that are forwarded to the 
Surveillance Department for review; and Floor Officials will continue 
to monitor the activities of LMMs, including those activities that are 
brought to the attention of Floor Officials by members of the trading 
crowd.
    The Commission believes that the Exchange's proposal is reasonably 
designed to provide for the adequate training of LMM employees 
operating the Book. The Exchange has represented that initially, the 
LMM employees who will most likely operate the Book will be former 
Exchange OBOs or present LMM employees who currently work with Exchange 
OBOs in apprentice-like fashion in the Program. Additionally, the 
Exchange has stated its willingness to assist LMM training efforts with 
their staff and facilities although participating LMMs will retain the 
primary responsibility to ensure the adequate training of their Book 
staff. The Commission believes that the structure of the Program, along 
with the supervision and oversight by the LMMs and Exchange, should 
help to ensure that LMM-employed OBOs are adequately trained.
    The Commission also believes that the proposal should help LMMs 
control their operational costs, as LMMs using their own staff to 
administer book functions will no longer have to pay Exchange personnel 
staffing charges, except during unusual market

[[Page 38066]]

circumstances. Additionally, the proposal should reduce Exchange costs 
associated with providing staff to operate the Book.\28\ By permitting 
the Exchange to reduce Program costs and allocate its resources to 
other regulatory areas the Commission finds that the proposal is 
consistent with the Act. The Commission believes that the proposal is 
reasonably designed to maintain, without disruption to activities on 
the Exchange's Options Trading Floor, the effective operation of the 
Book functions and therefore is consistent with the Act.
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    \28\ Telephone conversation between Robert P. Pacileo, Staff 
Attorney, Regulatory Policy, PCX and Marc McKayle, Attorney, 
Division, Commission on June 23, 1999.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\29\ that the proposed rule change, as amended, (SR-PCX-98-02) is 
approved.

    \29\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\30\
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    \30\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-17885 Filed 7-13-99-; 8:45 am]
BILLING CODE 8010-01-M