Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the Chicago Board Options Exchange, Inc. Relating to Floor Brokerage Subsidies

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40419; File No. SR-CBOE-98-35]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by the Chicago Board Options Exchange, Inc. Relating to Floor

Brokerage Subsidies

September 9, 1998.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act) \1\ and Rule 19b-4 \2\ thereunder, notice is hereby given that

on July 27, 1998, the Chicago Board Options Exchange, Inc. (``CBOE'' or

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

(``Commission'') the proposed rule change as described in Items I, II,

and III below, which Items have been prepared by the CBOE. 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

Substance of the Proposed Rule Change

The Exchange proposes to adopt a new rule that would allow market-

makers in a trading crowd to subsidize the activity of floor brokers

who represent orders in that crowd. The proposed rule would also allow

market-makers to determine to subsidize the execution of orders from

the Exchange's public customer limit order book. Set forth below is the

text of the proposed rule.

* * * * *

(The entire rule is new.)

Chicago Board Options Exchange, Inc. Rules

Chapter II--Organization and Administration

Part C--Dues, Fees, and Other Charges; Market-Maker Surcharge for

Brokerage

Rule 2.40

(a) Definitions.

(i) Stationary Floor Broker. A Stationary Floor Broker (``SFB'') in

a particular option class is a floor broker (A) who has established a

business in the trading crowd for that class of accepting and executing

orders for members or registered broker-dealers and (B) who transacted

at least 80% of his orders for the previous month in the trading crowd

at which that option class is traded.

(ii) Resident Market-Maker. A Resident Market-Maker in a particular

class of options is a market-maker who transacted at least 80% of his

market-maker contracts in option classes traded in the trading crowd

where the particular option class is traded in the prior calendar

month.

(iii) ORS Orders. For purposes of this Rule, an ORS order is an

order that is (A) sent over the Exchange's Order Routing System, (B)

given an ORS identification number and (C) not an order of the firm for

which the SFB acts as a nominee or for whom the SFB has registered his

membership.

(iv) Standard OBO Rate. The Standard OBO Rate is any rate for OBO

floor brokerage established by the Exchange for the particular equity

option class traded on the Exchange floor.

(b) Generally.

The Resident Market-Makers for a particular option class may vote,

as set forth in paragraph (d) of this Rule, to impose a fee on a per

contract basis for every contract traded by every market-maker, whether

in-person or by order, in that option class during the period for which

the fee is instituted. This fee will be collected by the Exchange and

used to reimburse the Exchange to the extent the market-makers vote to

reduce the Exchange's book rate pursuant to paragraph (g) of this Rule.

Any amount remaining after the Exchange has been reimbursed will be

paid to every SFB who executed an ORS Order in that option class during

the relevant period of time. To the extent more than one SFB executed

ORS Orders during the relevant period, this amount remaining shall be

paid to the SFBs on a pro rata basis based on the number of ORS

contracts executed by the respective SFBs during the period. The fee

likely will be assessed after the end of the

[[Page 49620]]

month in which transactions on which the fee was based occurred.

(c) Time Period.

The fee shall be instituted for a minimum period of one month. The

fee voted upon shall remain effective until the next vote is held.

(d) Vote.

(i) Any Resident Market-Maker may recommend a fee amount by the

Friday prior to the vote or by any other time and date required by the

OBO. The vote of the Resident Market-Makers to institute the fee shall

take place at the station where the applicable option class is traded

on the Tuesday of expiration week, or on any other day selected by the

OBO for that option class. The Order Book Official (``OBO'') shall

provide 24 hour notice of the time and date of the vote to the trading

crowd if the vote is to be held at a different time or on a different

day. The OBO shall determine how the vote shall be conducted. Any

Resident Market-Maker personally present at the trading station when

the vote is conducted may vote on the amount of the fee to be assessed

for the next period.

(ii) Each Resident Market-Maker's vote shall be weighted in

accordance with that Market-Maker's percentage of the contracts traded

in the relevant option class during the six calendar months prior to

the month in which the vote is taken. For example, the vote of a

Market-Maker that traded 5% of the contracts in the previous month will

be counted five times as much as the vote of a Market-Maker that traded

1% of the contracts in that options class over the previous six

calendar months. In the case of a class that has not traded for six

months, the weighting shall be determined in accordance with the

respective number of trades for the period of time the option class has

traded. For a class that has not traded at all, all Resident Market-

Maker's votes shall be weighted equally.

(iii) Any fee amount that receives a majority of the votes cast by

weight shall be the fee effective for the following calendar month. If

any fee amount does not receive a majority by weight on the first

ballot, the OBO may conduct subsequent ballots with the proposed fees

receiving the most votes by weight or may solicit Resident Market-

Makers for other proposed fee amounts.

(e) Option Classes.

The appropriate Floor Procedure Committee may specify those option

classes on which Resident Market-Makers may vote to assess a fee

pursuant to paragraph (d) of this Rule.

(f) Floor Brokerage Commission.

Although any SFB who executes ORS Orders in the crowd will be paid

the appropriate fee, each SFB may charge any commission rate that floor

broker so desires.

(g) Book Brokerage Rates.

The Resident Market-Makers for a particular option class may vote

to reduce the Exchange's OBO brokerage rate for that option class

pursuant to the terms of the vote in paragraph (d). If the Resident

Market-Makers vote to reduce the OBO brokerage rate the Exchange will

make the appropriate filing as required by the Exchange Act. To the

extent the Resident Market-Makers vote to lower the rate below the

Standard OBO Rate, the market-makers who trade that option class shall

reimburse the Exchange for the difference pursuant to any fee

instituted in paragraph (b). If the Exchange determines on its own to

reduce the OBO brokerage rate for a particular class below the Standard

OBO Rate the market-makers will not be responsible for reimbursing the

Exchange.

* * * * *

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. The text of these statements may be

examined at the places specified in Item IV below. The CBOE has

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

Many options traded on the CBOE floor are traded in crowds in which

the quotes are established in a competing market-maker system. The

Exchange believes the competitive market-maker system has served to

provide deep and liquid markets and extremely competitive quotes to the

benefit of the Exchange's customers throughout the twenty-five year

history of the Exchange. The Exchange has learned, however, that in

recent years it has become increasingly difficult for the floor brokers

who service customer orders in the Exchange's market-maker crowds to

compete in brokerage rates against options' specialists at other

exchanges in multiply-traded classes.

Unlike the situation in market-maker crowds, specialists control

both the agency and principal functions on other exchanges. As a

result, these specialists have the luxury of lowering their brokerage

rates to induce firms to send them the firm's order flow. These

specialists can still make a comfortable living, even while they reduce

their brokerage rates below a level at which the activity could be

provided economically as an independent venture, through the income

produced from the principal part of the business. The stationary floor

brokers on the CBOE floor, however, do not have the ability to reduce

their rates to compete with these specialists and still survive,

because (unlike these specialists on other exchanges) they have no

dealer profits. In some cases, these floor brokers have had to rely on

the superior service provided by the CBOE market-maker system to

attract order flow even in situations where their rates may be higher

than those charged by specialists on other exchanges. In order to allow

the Exchange's stationary floor brokers to compete better against other

exchange specialists without sacrificing the many advantages inherent

in having a number of option classes trade in the competing market-

maker crowds, the Exchange has determined to allow its market-makers to

provide a subsidy to the floor brokers to provide them the ability to

lower their rates and still earn an acceptable level of income.

a. Generally

The proposed rule would allow certain market-makers in a trading

crowd to vote to impose a fee on a per contract basis for every

contract traded by every market-maker, whether by person or by order,

in a particular option class. This fee will be collected by the

Exchange and will be used for two purposes. First, the amount collected

will be used to reimburse the Exchange to the extent the market-makers

vote to reduce the rate charged by the Exchange to execute Order Book

Official (``OBO'') orders. The amount paid the Exchange will be the

amount of the Standard OBO Rate minus the rate voted on by the market-

makers multiplied by the number of contracts executed by market-makers,

in person or by order. Any remaining amount of the subsidy collected

will then be paid to the stationary floor broker as an inducement for

that floor broker to reduce his brokerage rates. The Exchange believes

the proposed rule will allow the Exchange's market-maker crowds to

compete effectively for order flow against specialists from other

exchanges by allowing the brokerage

[[Page 49621]]

rates to be reduced to competitive levels. It should be noted that the

stationary floor broker would be entitled to charge whatever brokerage

rate he feels appropriate, but it is expected that the floor broker

will consider the extent to which his business is being subsidized by

the market-makers in the crowd in making that determination.

Generally, there is only one stationary floor broker in a trading

crowd. In some cases, where there is more than one stationary floor

broker in a trading crowd, the amount remaining after the Exchange has

been reimbursed will be paid to the stationary floor brokers on a pro

rata basis based on the number of Order Routing System (``ORS'') Orders

executed by each floor broker. For the sake of ease of administration,

the fee likely will be assessed after the end of the month in which

transactions on which the fee was based occurred.

b. Definitions

Proposed new Rule 2.40(a)(i) defines the category of brokers who

will be entitled to receive part of the market-maker subsidy as a

Stationary Floor Broker (``SFB''). An SFB in a particular option class

is a floor broker (A) who has established a business in the trading

crowd for that class of accepting and executing orders for members or

registered broker-dealers, and (B) who transacted at least 80% of his

orders for the previous month in the trading crowd at which that option

class is traded. The limitations in the definition are designed to

ensure that those floor brokers who have made a commitment to the

particular option class and who are willing to accept orders from a

wide variety of market participants are the ones who will benefit from

the subsidy. It is these floor brokers whose reduced brokerage rates

for a class of options will be most likely to attract or retain order

flow in that class, which will be of benefit to the market-makers in

the trading crowd for that class of options.

Proposed new Rule 2.40(a)(ii) defines that category of market-

makers who will be entitled to vote on the market-maker surcharge and

on any reduction from the Standard OBO Rate as a Resident Market-Maker.

A Resident Market-Maker is defined as a market-maker in a particular

option class who transacted at least 80% of his market-maker contracts

in option classes traded in the trading crowd where the particular

option class is traded in the prior calendar month. The limitation in

this definition ensures that those market-makers who have made a

commitment to fulfilling their market-maker obligations in the relevant

trading crowd are the ones who determine to what extent they will be

willing to compete to attract business to the trading crowd.

Proposed new Rule 2.40(a)(iii) defines the types of orders for

which SFBs can earn a subsidy. An ORS Order, for purposes of this rule,

is an order sent over the Exchange Order Routing System and given an

ORS identification number and that is not an order of the firm for whom

the SFB acts as a nominee or for whom the SFB has registered his

membership. The Exchange decided to make the determination on the

amount of a subsidy an SFB receives by reference to the number of ORS

contracts that SFB executed because the rate the SFB charges for ORS

orders is most likely to be the rate which will attract the most order

flow. Non-ORS orders--such as spreads, large telephone orders, and

complex or contingent orders--may require more effort and expertise

from the floor broker and are not as sensitive to rates as to level of

service. In addition, the Exchange determined not to allow ORS orders

executed by an SFB on behalf of the firm for whom the SFB is a nominee

or for whom he has registered his membership because these orders will

be executed by the SFB by virtue of the relationship and not by virtue

of the rate charged.

c. Option Classes/Time Period

The Exchange has determined to allow the appropriate Floor

Procedure Committee to determine on which classes of options the

market-makers will have the authority to vote to assess a fee and to

reduce the OBO brokerage rate. The Exchange believes that it is likely

that the program will be started in a few options classes initially to

determine the effects of the program on allowing the market-maker

crowds to compete with specialists from other options exchanges. Over

time it is expected that the program may be expanded more broadly

across the floor. Any subsidy agreed to be paid by the market-makers

would have to be in effect for at least one month in order not to

disrupt normal Exchange billing and accounting procedures.

d. Voting Procedures

Proposed new Rule 2.40(d)(i) requires that the vote of the Resident

Market-Makers to institute a fee shall take place in the crowd where

the applicable option class is traded and the vote will be conducted by

the OBO in that option class. The normal date and time set for the vote

will be 8:15 a.m. on the Tuesday of expiration week. Expiration week is

chosen because that is the week when the attendance is generally

highest. The OBO, however, can set a different time and/or date by

providing a 24-hour notice of the different time and/or date. Any

Resident Market-Maker in the crowd at the time of the vote will be

entitled to vote on the amount of the fee or on any reduction in the

OBO brokerage rate for the next calendar month. The votes shall be

weighted in accordance with the number of contracts traded by the

particular market-maker in the relevant option class in the six

calendar months prior to the vote. For example, the vote of a Resident

Market-Maker that traded 5% of the contracts in the previous six

calendar months will be counted five times as much as the vote of a

Market-Maker that traded 1% of the contracts in that options class over

the previous six calendar months. In the case of a class that has not

traded for at least six months, the weighting shall be determined in

accordance with the respective number of trades for the period of time

the option class has traded. For a class that has not traded at all,

all Resident Market-Makers' votes shall be weighted equally.

Any proposed fee amount that receives a majority of the weighted

votes shall become effective for the next calendar month. If any fee

amount does not receive a majority by weight on the first ballot, the

OBO may conduct subsequent ballots by seeking approval of the proposed

fees receiving the most votes by weight or by seeking approval for

other fee amounts proposed by Resident Market-Makers. Similarly, the

Resident Market-Makers may vote to reduce the OBO brokerage rate to the

rate receiving the majority of the weighted votes being effective for

the next calendar month. Again, the OBO may conduct subsequent votes if

no proposed OBO brokerage rate received the majority of the weighted

votes. If the Exchange determines to reduce the OBO brokerage rate for

a particular class of options to a new lower Standard OBO Rate, the

market-makers will not be responsible for reimbursing the Exchange.

2. Statutory Basis

The proposed rule change is consistent with Section 6(b)( \3\ of

the Act in general and further the objectives of Section 6(b)(5) \4\ in

particular in that they are designed to promote just and equitable

principles of trade and to protect investors and the public interest.

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\3\ 15 U.S.C. 78f(b).

\4\ 15 U.S.C. 78f(b)(5).

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[[Page 49622]]

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

The proposed rule change is anticipated to enhance the ability of

market-makers to compete with the other exchanges for order flow.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants or Others

No written comments were solicited or received with respect to the

proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing

for Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period: (i) As the Commission

may designate up to 90 days of such date if it finds such longer period

to be appropriate and publishes its reasons for so finding, or (ii) as

to which the self-regulatory organizations consents, the Commission

will:

(A) By order approve 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 proposal is

consistent with the Act. 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 20549.

Copies of such filing will also be available for inspection and copying

at the principal office of CBOE. All submissions should refer to File

No. SR-CBOE-98-35 and should be submitted by October 7, 1998.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\5\

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\5\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98-24819 Filed 9-15-98; 8:45 am]

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