Self-Regulatory Organizations; Order Approving and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 1 to a Proposed Rule Change by the Philadelphia Stock Exchange, Inc., Relating to Enhanced Specialist Participation in Parity Options Trades.

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34109; File No. SR-Phlx-93-29]

Self-Regulatory Organizations; Order Approving and Notice of

Filing and Order Granting Accelerated Approval of Amendment No. 1 to a

Proposed Rule Change by the Philadelphia Stock Exchange, Inc., Relating

to Enhanced Specialist Participation in Parity Options Trades.

May 25, 1994.

On August 9, 1993, the Philadelphia Stock Exchange, Inc. (``Phlx''

or ``Exchange'') filed with the Securities and Exchange Commission

(``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 enhanced specialist participation in

parity options trades. Notice of the proposal appeared in the Federal

Register on September 20, 1993.\3\ One comment letter was received

opposing the proposed rule change,\4\ to which the Phlx responded.\5\

On April 19, 1994, the Exchange filed Amendment No. 1.\6\ This order

approves the Exchange's proposal, as amended.

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\1\15 U.S.C. 78s(b)(1) (1988).

\2\17 CFR 240.19b-4 (1992).

\3\See Securities Exchange Act Release No. 32891 (September 14,

1993), 58 FR 48921.

\4\See Letter from Jay Mizrahi, General Partner, P.J. Shoreline

Securities (``Shoreline''), to Jonathan Katz, Secretary, Commission,

dated December 16, 1993 (``Shoreline Securities Letter'').

\5\See Letter from William Uchimoto, Vice President and General

Counsel, Phlx, to Sharon Lawson, Assistant Director, Office of

Derivatives and Equity Oversight (``ODEO''), Division of Market

Regulation (``Division''), Commission, dated February 23, 1994

(``Phlx Response Letter'').

\6\On April 19, 1994, the Exchange filed Amendment No. 1 to the

proposed rule change to specify that: (1) The Exchange's Allocation,

Evaluation and Securities Committee (``Committee'') may only extend

the proposed six month Enhanced Parity Split (as defined herein) for

one additional six month period; and (2) the Enhanced Parity Split

cannot cause a customer order to receive a smaller participation as

a result of this rule than any other crowd participant, including

the specialist. Further, Amendment No. 1 clarifies that (1) a ``New

Unit'' would be any new equity options specialist unit approved by

the Exchange on or after June 16, 1993; (2) a `New Options Class''

is any class of options listed for trading by the Exchange on or

after June 16, 1993; and (3) the Enhanced Parity Split may be

granted for a New Options Class after the initial six month period

has expired as long as the New Options Class is assigned to the New

Unit while it is still entitled to receive the Enhanced Parity Split

pursuant to the proposed rule change on the first New Options Class

it commenced trading. See Letter from Michele Weisbaum, Associate

General Counsel, Phlx, to Michael Walinskas, Branch Chief, ODEO,

Division, Commission, dated April 19, 1994 (``Amendment No. 1'').

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Description of Proposal

In order to encourage the registration with the Exchange of New

Units,\7\ the Exchange proposes to add now Commentary .17 to Rule 1014.

Specifically, the proposal would enable New Units trading New Options

Classes,\8\ to execute 50% of the contracts in transactions where the

New Unit is on parity with one registered options trader (``ROT''), and

40% of the contracts in a transaction where the New Unit is on parity

with two or more ROTs (``Enhanced Parity Split''); provided, however,

that no customer order which is on parity may receive a smaller

participation than any other crowd participant, including the

specialist.\9\

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\7\See Amendment No. 1, supra note 6.

\8\id.

\9\In such cases, the specialist may waive the Enhanced Parity

Split. Telephone conversation between Michele Weisbaum, Associate

General Counsel, Phlx, and Brad Ritter, Attorney, ODEO, Division,

Commission, on May 20, 1994.

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A New Unit can be formed by current ROTs and/or specialists as long

as a new broker-dealer firm is established. Because the proposal will

be limited to New Options Classes, options classes that are leased or

otherwise transferred from an existing specialist to a New Unit, or

that were listed on the Exchange prior to June 16, 1993, and which are

assigned to a New Unit, and not covered by the proposed rule.

The Enhanced Parity Split would be effective for a period of six

months from the commencement of trading by the New Unite of its first

New Options Class.\10\ Furthermore, the Committee may extend the

Enhanced Parity Split for one additional six month period upon petition

by the New Unit and a determination by the Committee that such

extension is consistent with the promotion of just and equitable

principles of trade and the public interest.\11\ The Enhanced Parity

Split will also be applicable to any additional New Options Classes

that are assigned to a New Unit, provided that at the time such classes

are assigned, the New Unit is still entitled to receive the Enhanced

Parity Split on the first New Options Class it commenced trading

pursuant to this rule.\12\ The Committee may terminate any extension of

the Enhanced Parity Split if the Committee determines that such action

is consistent with the promotion of just and equitable principles of

trade and the public interest.\13\

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\10\On August 17, 1992, the Exchange filed a similar proposal

pursuant to which all specialists would have received the enhanced

parity split contained in this proposal. See File No. SR-Phlx-92-19.

The Exchange has withdrawn that proposal. See Letter from Keith

Kessel, Phlx, to Brad Ritter, Attorney, Office of Derivatives

Regulation, Division of Market Regulation, Commission, dated

December 2, 1993. On February 28, 1994, the Exchange filed another

proposal which provides for a different form of enhanced parity

participation for existing specialist units and for New Units that

become ineligible for the Enhanced Parity Split pursuant to this

proposal. See Securities Exchange Act Release No. 33935 (April 20,

1994), 59 FR 22038 (April 28, 1994) (notice of File No. SR-Phlx-94-

12). If approved, the enhanced parity participation for specialists

proposed in File No. SR-Phlx-94-12 would not be available to New

Units that are eligible for the Enhanced Parity Split pursuant to

this proposal. Telephone conversation between Michele Weisbaum,

Associate General Counsel, Phlx, and Brad Ritter, Attorney, ODEO,

Division, Commission, on April 20, 1994.

\11\See Amendment No. 1, supra note 6.

\12\Once granted, the Enhanced Parity Split on additional New

Options Classes assigned to a New Unit may remain in effect for up

to one year as provided herein even though the Enhanced Parity Split

on the first New Options Class assigned to the New Unit terminates

during that time period. Id.

\13\The Exchange represents that a New Unit will need the

initial six month period in order to establish a trading record in

the New Options Class. If, however, the New Unit's performance

during the initial six month period is substandard, the Committee

may reallocate the particular options class to another specialist

pursuant to Phlx Rule 511. See Letter from William Uchimoto, General

Counsel, Phlx, to Richard Zack, Branch Chief, ODEO, Division,

Commission, dated January 5, 1994.

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Comment Letter

The Comment letter received opposing the proposed rule change made

several arguments as to why the proposed rule change is

inappropriate.\14\ The commenter first argues that the Exchange has no

evidence that granting an Enhanced Parity Split to New Units will in

any way benefit Phlx public customers. In fact, the letter argues that

the proposed rule is anti-competitive and will ultimately harm public

customers by acting as a disincentive for ROTs to make competitive

markets, thus removing liquidity from the market. Shoreline believes

that price competition is restricted whenever the specialist is granted

a benefit not available to the ROTs in the crowd. Shoreline also argues

that there is no evidence that the Enhanced Parity Split will encourage

New Units to make tight and liquid markets, as the Phlx claims.

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\14\See Shoreline Securities Letter, supra note 4.

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The commenter's next argument is that the proposed rule allows, but

does not require, the New Unit to invoke the Enhanced Parity Split.

Shoreline believes that this further harms ROTs because there may be

instances where ROTs are forced to accept a greater percentage of an

undesirable trade than they would if the New Unit is required to accept

the Enhanced Parity Split.

Shoreline also argues that by allowing existing specialists and

ROTs to form New Units, the proposal does not serve its stated purpose,

which is to encourage the formation and registration with the Exchange

of new specialist units.

Finally, the commenter argues that the Phlx has provided no

specific criteria for maintaining or revoking the Enhanced Parity Split

with respect to a particular New Options Class. Shoreline believes that

if the Enhanced Parity Split is to be offered to New Units, the

Committee should have objective standards to apply in making a

determination of whether to extend the Enhanced Parity Split for the

allowed additional six month period.

Phlx Response

The Phlx refutes the arguments raised by Shoreline.\15\ First, the

Phlx believes that the proposal will in fact add liquidity to the

market, thus directly benefiting public customers. The Phlx believes

the proposal will attract new specialist units to the Exchange and will

encourage these New Units to make tight markets in New Options Classes

in order to attract order flow to the Exchange. The Phlx argues that

because every newly listed options class is subject to multiple

listings, disincentives are created which discourage specialist units

from acting as specialists for those new classes of options. The Phlx

believes that the Enhanced parity Split will counteract these

disincentives by offering New Units a direct benefit if they are able

to attract order flow to the Exchange. The Exchange believes the New

Units will be able to attract this order flow, and thus capitalize on

the Enhanced Parity Split, only if they maintain tight markets in the

New Options Classes. As a result, the Phlx believes that public

customers will directly benefit from the proposed rule change.

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\15\See Phlx Response Letter, supra note 5.

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The Phlx also disagrees with Shoreline's contention that any

enhanced split is anti-competitive. First, the Enhanced Parity Split is

available to any market making firm that is willing to establish a New

Unit. Secondly, the proposal does not impact parity splits on existing

options classes or New Options Classes traded by existing specialist

units. Finally, a market maker can always establish priority in a trade

by improving the market or by being the first in establishing a market

that would otherwise be on parity.

In response to the commenter's claims that market makers are

unfairly disadvantaged by this proposal, the Phlx makes several

arguments. First, the Phlx states that the claims that market makers

will be hampered in hedging trades where they improve the market does

not take into account the possibility that the market maker may be able

to hedge by improving both sides of the market or by utilizing another

options series for purposes of hedging. Additionally, the proposal does

not impact in any manner the ability of a market maker to hedge an

options position with underlying stock. Further, the Phlx argues that

specialists have responsibilities and are subject to certain costs that

market makers do not have, such as, updating and disseminating quotes,

reflecting all market interest in the displayed quotes, and the fixed

staffing cost committed to market making in a particular issue whether

it is active or not. In order to attract specialist units to the

Exchange who are willing to accept these responsibilities, the Phlx

believes it is necessary to provide specialists with some benefits that

are not available to ROTs. The Phlx believes that any negative impact

to ROTs that may be caused by this proposal is more than offset by the

benefit to the Exchange and its customers of attracting New Units to

the Exchange.

The Phlx also refutes the commenter's claim that ROTs are further

harmed because the New Unit is not required to invoke the Enhanced

Parity Split. The Phlx argues that because specialists and ROTs both

desire to buy at the bid and sell at the ask, there should be few

undesirable trades where the specialist would not find it desirable to

invoke the Enhanced Parity Split. As a result, the Exchange believes

that any negative impact on the ROTs as a result of the permissive

nature of the rule will be de minimis.

Finally, the Phlx argues that because the Enhanced Parity Split can

apply to a New Options Class for at most one year, the Exchange does

not believe that detailed evaluative criteria for use in awarding or

removing the Enhanced Parity Split will be particularly effective or

necessary. The Exchange believes that by the time that the New Unit

establishes a trading history which can be reviewed and evaluated, the

Enhanced Parity Split will probably have lapsed. Even without such

criteria, however, the Phlx notes that the Committee has the ability to

review the performance of a New Unit and to remove the Enhanced Parity

Split at the end of the initial six month period, or in more egregious

cases, to reallocate an options class for inadequate specialist

performance.

Discussion

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, and, in

particular, the requirements of section 6(b)(5)\16\ in that the

proposal is designed to promote just and equitable principles of trade,

to remove impediments to and perfect the mechanism of a free and open

market, and protect investors and the public interest. Specifically,

the Commission finds that the proposal may serve to remove impediments

to and perfect the mechanism of a free and open market by encouraging

the creation of New Units and by encouraging those New Units to

maintain tight markets for New Options Classes in order to attract

order flow to the Exchange. The Commission believes the proposed rule

change is a reasonable attempt by the PHlx to enhance the ability of

New Units to compete for order flow in the environment of multiply-

traded options classes. In addition, the protection of investors and

the public interest is maintained because the Committee can refuse to

extend the Enhanced Parity Split for an additional six months if the

performance of the New Unit does not warrant an extension. Further, the

proposed rule change provides the Enhanced Parity Split cannot

disadvantage a public customer order that is on parity with a New

Unit.\17\

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\16\15 U.S.C. 78f(b)(5) (1988).

\17\See Amendment No. 1, supra note 6.

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The Commission agrees with the Exchange that in order to attract

order flow to the Exchange, the Phlx needs to be able to attract and

retain well capitalized specialist units that are willing to trade New

Options Classes, as well as existing options classes. Further, the

Commission disagrees with the commenter that the proposed rule change

will disadvantage public customers. On the contrary, the proposed rule

change eliminates any direct injury to public customers by providing

that customer orders on parity may not receive a smaller participation

than any other crowd participant, including the specialist.\18\

Furthermore, because the proposal may serve to add liquidity to the

market by encouraging New Units to maintain tight markets in order to

attract order flow to the Exchange, the Commission believes that public

customers could benefit from the proposed rule change.\19\ Accordingly,

the Commission believes there is no evidence to support a conclusion

that the proposed rule change will disadvantage public customers.

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\18\The specialist may waive the Enhanced Parity Split in these

circumstances. See supra note 9.

\19\The Commission notes that contrary to the commenter's

contention, ROTs may in fact benefit from the Enhanced Parity Split

if the New Units are successful in attracting order flow to the

Exchange.

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The Commission also acknowledges that specialists have

responsibilities that ROTs do not have and that these responsibilities

have certain costs associated with them, such as the staff costs

associated with continually updating and disseminating quotes. As a

result, the Commission believes it is reasonable for the Exchange to

grant certain advantages, such as the Enhanced Parity Split, to New

Units in order to encourage New Units to register as specialists for

New Options Classes. Accordingly, as long as these advantages do not

unreasonably restrain competition and do not harm investors, the

Commission believes that the granting of such benefits to specialists

is within the business judgment of the Exchange. Therefore, even though

the proposed rule change could arguably have some negative impact on

ROTs, for the reasons stated above, the Commission believes the

proposal is consistent with the Act.\20\

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\20\Further, the Commission disagrees with the commenter that

ROTs may be disadvantaged by the fact that New Units are not

required to accept the Enhanced Parity Split in those instances

where it applies. In those cases where a New Unit determines to

waive the Enhanced Parity Split, the Exchange's normal parity rules

will apply and the ROTs involved will be no worse off than they

would on any other parity trade.

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Finally, the Commission agrees with the Phlx that the lack of

quantifiable standards for the Committee to apply in determining

whether to extend the Enhanced Parity Split for an additional six month

period does not make the proposal unreasonable. Even if the Phlx

proposed such standards, some time period would be necessary in order

for the New Unit to establish a trading history in the New Option Class

in order for such a review to have any validity. In addition, the

Committee still will review the performance of the New Unit in

determining whether to extend the Enhanced Parity Split for an

additional six months for particular New Options Classes. Because the

Enhanced Parity Split can be in effect for at most one year for each

New Options Class, the Commission believes that the lack of such

standards does not prevent a finding that the proposal is consistent

with the Act.

The Commission finds good cause for approving Amendment No. 1 to

the proposed rule change prior to the thirtieth day after the date of

publication of notice of filing thereof in the Federal Register. First,

Amendment No. 1 limits to one year the maximum time period during which

the Enhanced Parity Split can exist with respect to any New Options

Class and provides that the proposed rule cannot disadvantage customer

orders. The purpose of the Enhanced Parity Split is to encourage New

Units to maintain tight spreads in New Options Classes, which is a

benefit to investors. The Commission believes that providing such an

incentive to specialists is appropriate for New Options Classes for the

period during which the market for such options classes is being

established as long as safeguards exist to ensure that customers are

not harmed. As a result, the Commission believes these amendments

accomplish these goals consistent with the Act. Secondly, Amendment No.

1 also clarifies certain aspects of the proposed rule change. The

Commission believes that these amendments strengthen the proposed rule

change by minimizing any confusion that may arise as to the

applicability of the rule. As a result, the Commission believes it is

consistent with section 6(b)(5) of the Act to approve Amendment No. 1

to the Phlx's proposal on an accelerated basis.

Interested persons are invited to submit written data, views, and

arguments concerning Amendment No. 1 to the proposed rule change.

Persons making written submissions should file six copies thereof with

the Secretary, Securities and Exchange Commission, 450 Fifth Street,

NW., Washington, DC 20549. 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 inspection and copying in the Commission's Public

Reference Section, 450 Fifth Street, NW., Washington, DC. Copies of

such filing will also be available for inspection and copying at the

principal office of the Exchange. All submissions should refer to File

No. SR-Phlx-93-29 and should be submitted by June 23, 1994.

It is therefore ordered, pursuant to section 19(b)(2) of Act,\21\

that the proposed rule change (SR-Phlx-93-29) is hereby approved, as

amended.

\21\15 U.S.C. 78s(b)(2) (1988).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\22\

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\22\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-13344 Filed 6-1-94; 8:45 am]

BILLING CODE 8010-01-M