Self-Regulatory Organizations; Pacific Exchange, Inc.; Order Granting Accelerated Approval of Proposed Rule Change and Amendments 1 and 2 Thereto and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 3 to Proposed Rule Change Relating to Automated Opening Rotations

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41970; File No. SR-PCX-99-24]

Self-Regulatory Organizations; Pacific Exchange, Inc.; Order

Granting Accelerated Approval of Proposed Rule Change and Amendments 1

and 2 Thereto and Notice of Filing and Order Granting Accelerated

Approval of Amendment No. 3 to Proposed Rule Change Relating to

Automated Opening Rotations

September 30, 1999.

I. Introduction

On July 13, 1999, the Pacific Exchange, Inc. (``PCX'' 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 to adopt a new Automated Opening Rotation

(``AOR'') system for handling customer orders and executing option

transactions during the opening rotation. On August 4, 1999, the

Exchange filed with the Commission Amendment No. 1 to the proposed rule

change.\3\ Notice of the proposed rule change, as amended, appeared in

the Federal Register on August 30, 1999.\4\ The Commission received no

comments regarding the proposal. On September 1, 1999, the PCX filed

Amendment No. 2 to the proposal.\5\ Notice of Amendment No. 2 appeared

in the Federal Register on September 10, 1999.\6\ On September 27,

1999, the Exchange filed Amendment No. 3.\7\ This Order approves the

proposed AOR pilot until October 1, 2000, as amended. In addition, the

Commission is publishing this notice to solicit comments on Amendment

No. 3 and is simultaneously approving the Amendment No. 3.

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

\2\ 17 CFR 240.19b-4.

\3\ See Letter from Michael D. Pierson, Director, Regulatory

Policy, PCX, to Michael A. Walinskas, Associate Director, Division

of Market Regulation (``Division''), Commission, dated August 3,

1999 (``Amendment No. 1'').

\4\ See Securities Exchange Act Release No. 41774 (August 20,

1999), 64 FR 47210.

\5\ See Letter from Michael D. Pierson, Director, Regulatory

Policy, PCX, to Richard Strasser, Assistant Director, Division,

Commission, dated September 1, 1999 (``Amendment No. 2'').

\6\ See Securities Exchange Act Release No. 41824 (September 1,

1999), 64 FR 49263 (noticing additions to the proposed rule change

and granting partial accelerated approval for the implementation of

AOR for 16 issues on a thirty day pilot basis). The Commission notes

that the PCX has represented that the Exchange has not experienced

any problems with AOR on the 16 pilot issues. Telephone conversation

between from Michael D. Pierson, Director, Regulatory Policy, PCX,

and Terri Evans, Attorney, Division, Commission, on September 30,

1999.

\7\ In Amendment No. 3, the Exchange proposes to implement the

AOR system for all issues on a one-year pilot basis. See Letter from

Michael D. Pierson, Director, Regulatory Policy, PCX, to Richard C.

Strasser, Associate Director, Division, Commission, dated September

24, 1999 (``Amendment No. 3'').

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II. Description of Proposal

The Exchange is proposing to adopt a new procedure that will allow

the Order Book Official (``OBO'') to establish electronically, for

eligible options series, a single price opening for executing eligible

market and marketable limit orders in the POETS system. The PCX

proposes to implement the new procedure on a one-year pilot basis until

October 1, 2000.\8\ In the event of an imbalance, any remaining orders

in the system that are eligible to be executed will be assigned to

market makers participating on the Auto-Ex System. The new process

involves three basic steps: first, the markets are established; second,

the opening rotation is automatically processed for the majority of

series; and finally, any series with manual orders or complication is

opened manually, i.e., pursuant to the current procedures for opening

rotations.\9\

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\8\ Id.

\9\ See Securities Exchange Act Release No. 41774, supra note 4.

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More specifically, under the new AOR process, opening rotations on

the PCX will occur in the following manner: Prior to the opening the

OBO will determine whether there are any orders in the trading crowd to

be executed at the opening.\10\ Once the underlying

[[Page 54714]]

security has opened and the Auto-Quote values are established,\11\ the

OBO will request from the trading crowd bids and offers in the specific

option issue. The trading crowd may determine that the posted bids and

offers are accurate, or alternatively, may request by public outcry

that certain quotes be modified.

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\10\ These may include, for example, orders that cannot be

represented in POETS, such as contingency orders, broker/dealer

orders, orders designated ``not held,'' orders for spreads or

straddlers, combination orders, all-or-none orders, as well as any

order the floor broker determines to represent manually.

\11\ Telephone conversation between Michael D. Pierson,

Director, Regulatory Policy, PCX and Terri Evans, Attorney, Division

Commission on September 21, 1999.

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Once the bid and asking price in each series has been ascertained,

the OBO and AOR System will identify all series that are eligible for

the AOR and that can be opened immediately, and will also identify all

series that are not eligible for the AOR. Those that are not eligible

for the AOR must be opened manually. Procedures for automatic and

manual opening are discussed below.

A. Automatic Opening

To prepare for an automated opening the AOR will first exclude

series for which there are no market or marketable limit orders in the

system, as well as all series deemed ineligible for AOR. The series

eligible for AOR will be promptly opened in accordance with the

following principles and procedures: First, the system will determine a

single price at which the series will be opened.\12\ Second, orders in

the system will maintain priority over market maker bids and offers, so

orders in the system will be matched up with on another,if possible,

before executing against the accounts of market makers. Third, if there

is an imbalance in the number of contracts to buy or sell at the

opening, then the imbalance will be ``cleaned up'' by the market makers

who are participating on the Auto-Ex system, i.e., the system will

assign a set number of contracts to each participating market maker

until the imbalance has been exhausted. Under the proposal, the

imbalance will be allocated to the members of the trading crowd using

the Exchange's existing Auto-Ex system.

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\12\ The appropriate price that is used in a single price

opening is determined in the following manner: Once the bid and

offering prices in a particular series have been determined, the OBO

will identify the number of contracts available to sell at the bid

price and the number of contracts available to buy at the offering

price. If the number available to sell at the bid price is greater

than the number available to buy at the offering price, then the

opening price will be the bid price, and vice versa. If the number

of contracts to sell is equal to the number to buy, then the opening

price will be established halfway between the bid and offering

price. However, if there is no trading increment available at the

halfway point between the bid and offering prices (e.g., as in the

case of a market 2 bid, 2\1/16\, asked), then the opening price will

be established at the price closest to the last sale price of option

contracts of that series.

If market and marketable limit orders can be completely

satisfied by trading against other orders in the Book, then the

market may open between the established bid and ask prices, with no

market maker participation. For example, if the market is 22\1/4\,

with an order in the Book to sell 20 contracts at 2\1/8\, and a

market order to buy 5 contracts, the single price opening will occur

with 5 contracts trading at 2\1/8\ (public customer to public

customer). The market quote at the opening will then be 22\1/8\.

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Under the proposal, orders may participate in the AOR regardless of

size. An order will not be prohibited from participating in the

automated opening rotation on the ground that the order is ineligible

from being executed over the Auto-Ex System due to its size.

The proposed rule change also provides for the manual accommodation

of certain non-bookable orders represented in the trading crowd and

disclosed to the OBO prior to an AOR. Generally, if the order is either

a market order or a limit order with a limit price equal to the opening

price of the particular series, then that order will be entitled to an

execution immediately following the opening of that series. If the

order is a market order or limit order for a public customer, the order

will be filled in its entire size by the market makers in the trading

crowd. If the order is a limit order for a broker-dealer, the order

will be entitled to be filled up to a number of contracts equal to a

pro rata share of the number of contracts that the Auto-Ex system

assigns to the market makers. If a broker is holding more than one

order to trade at the same limit price, then that broker is limited to

no more than one pro rata share of the number of contracts that the

Auto-Ex System assigns to the market makers.

B. Manual Opening

The Exchange intends to use the AOR in all issues traded on the

PCX. The Exchange also expects that particular series will only be

designated for manual opening (i.e., ``de-selected'' from the automated

procedure) in unusual circumstances. The Exchange does not anticipate

any situations where all series of a given issue will be opened

manually when the AOR is operational. The Exchange also does not

anticipate that any particular series will be de-selected and opened

manually on a routine or regular basis.

As noted above, all series that are not eligible for AOR will have

been identified before any series are opened automatically. The OBO can

designate a series as ineligible for the AOR by deliberately not

entering a quote into the system for that series. Series not eligible

for the AOR include series for which: (a) There are orders requiring

special handling; \13\ (b) there is an imbalance of contracts exceeding

an established threshold; or (c) the trading crowd and OBO determine

that the series should be opened manually.

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\13\ The following types of orders are ineligible to participate

in the automated opening rotation: (1) Broker/dealer orders; (2)

contingency orders; (3) spreads; (4) straddles; (5) not held orders;

and (6) combination orders. These types of orders are defined in PCX

Rule 6.62. If any of these types of orders are being represented in

the trading crowd and are likely to participate in the opening based

on price, a manual opening rotation will be held in that series.

Market orders are plain limit orders (i.e., limit orders with no

contingencies) are eligible to participate in the AOR.

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1. Manual Orders Requiring Special Handling

A series will be deemed ineligible for AOR if a broker in the crowd

is holding an order \14\ that is likely to be executed during the

opening. In general, manual orders to buy at relatively low prices or

to sell at relatively high prices generally will not likely participate

in the opening.

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\14\ The Exchange clarified that brokers hold orders as agent.

Telephone conversation between Michael D. Pierson, Director,

Regulatory Policy, PCX, and Kenneth Rosen, Attorney, Division,

Commission, on September 14, 1999.

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2. Imbalance of Contracts Exceeding Established Thresholds

The Exchange will establish, for each option issue, a number of

contracts that constitutes an imbalance threshold. Initially, each

option issue will have a minimum imbalance threshold of 20 contracts.

However, a Lead Market Maker in an issue may increase the imbalance

threshold in that issue to a number greater than 20, but not exceeding

999 contracts (due to system constrains). The decision to change the

imbalance threshold will be made as follows. Prior to the opening the

OBO, in conjunction with the Lead Market Maker in the issue, will set

for each option issue a number of contracts that constitute an

imbalance threshold. This number will attempt to reflect the relative

liquidity in the trading crowd and size of the following crowd.\15\ The

AOR will calculate imbalances on a series-by-series basis and flag

those series for which the imbalance threshold has been exceeded.

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\15\ The Options Floor Trading Committee will monitor and

supervise the general process of designating imbalance thresholds on

the trading floor. The Exchange believes that it is necessary to

provide a reasonable amount of flexibility in the process of

establishing particular thresholds. The Exchange also believes that

there is little risk of abuse in providing flexibility because if

low thresholds are established, then the series will have to be

opened manually. Although the Exchange does not anticipate that

there will be any problems in this area, the Exchange will study the

process during the first six months of use of the new system. If a

rule change appear necessary, the Exchange will file a rule filing

with the Commission to effect the changes necessary.

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[[Page 54715]]

3. Crowd's Request for Manual Opening

A member or members of a trading crowd may request a particular

series to be opened manually, and the OBO will honor reasonable

requests. These requests may typically be made in a series with a large

amount of open interest or for other reasons.\16\ Although the Exchange

does not anticipate problems resulting from such requests, in the event

of a dispute the matter would be resolved by floor officials.

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\16\ Generally, a series will not be eligible for an AOR if one

or more members of the trading crowd has reasonably requested a

manual opening rotation in that series. The Exchange anticipates

that such requests will fall into two general categories. The first

category involves mergers and takeovers. The second category would

cover system problems or system limitations. For example, the POETS

system may be unable to generate an accurate market because it is

unable to take into account the fact that a takeover will occur on

the following day, and as such, the system is unable to factor in

the correct model. In these situations, the series will be opened

manually.

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C. Obligations and Eligibility of Market Makers

Market makers may participate in the AOR if they are otherwise

eligible to participate on the Auto-Ex system during the trading day

pursuant to PCX Rule 6.87. Generally, to participate on Auto-Ex, a

market maker must be present in the trading crowd and that trading

crowd must be included within that market maker's appointment zone. If

there is adequate participation in a particular option issue, two floor

officials may require market makers who are members of the trading

crowd, as defined in subsection (6) of PCX Rule 6.87, to log on to

Auto-Ex, while present in the trading crowd, absent reasonable

justification or excuse for non-participation. The Exchange proposes

that these rules will apply to market maker participation in the AOR

with respect to contracts allocated to market makers during the opening

rotation process.

D. Surveillance of Market Maker Procedures

The market makers participating on AOR will be required to price

the contracts fairly, in a manner consistent with their obligations

under PCX Rule 6.37. In conjunction with the implementation of the AOR

system, the Exchange will publish a regulatory bulletin to remind

market makers of their obligation to set Auto-Quote fairly. The

Exchange believes that a number of factors, including scrutiny by

customers and firms representing customer orders, will ensure that

market makers adjust the Auto-Quote values consistent with their

obligation. Moreover, market makers are required to vocalize their

changes to Auto-Quote, which allows OBO's to oversee the markets and

alerts market makers who may want to improve the markets. In addition,

if an OBO notices any unusual activity in the setting of Auto-Quote

values the OBO must fill out an OBO Unusual Activity Report which will

be investigated by the Exchange. Finally, the Exchange's Auto-Quote has

an audit trail log that details every quote change resulting from the

use of Auto-Quote. This audit trail report can be studied in the event

of any concerns with the way the Auto-Quote values were established for

AOR.

III. Discussion

After careful review, the Commission finds that the proposed rule

change, as amended, is consistent with the requirements of Section 6 of

the Act. In particular, the Commission finds the proposal is consistent

with Section 6(b)(5) of the Act.\17\ Section 6(b)(5) requires, among

other things, that the rules of the exchange be designed to remove

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

a national market system and not be designed to permit unfair

discrimination between customers, issuers, brokers or dealers.

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\17\ 15 U.S.C. 78f(b)(5). In approving this rule, the Commission

has considered the proposed rule's impact on efficiency,

competition, and capital formation. 15 U.S.C. 78c(f).

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The proposed rule change represents an effort to facilitate the

execution of orders at the opening by providing an electronic means of

establishing a single price opening. The Exchange believes that this

will expedite the opening of option issues on the Exchange, which will

serve all market participants. Further, the Exchange believes it will

eliminate problems associated with later openings, including the

elimination of blacklogs of unexecuted orders that can result when

opening rotations are conducted entirely manually and thus, improve

market efficiency for all market participants. In addition, the

Commission believes that the proposal should promote fair participation

in openings by all market participants by providing for the

participation of non-market-maker broker-dealer orders in the opening

process.

The Commission recognizes that certain aspects of AOR may require

heightened scrutiny by PCX to ensure that market makers are not

permitted to use the flexibility they have to set an opening price to

the disadvantage of investors and other market participants. The

Exchange has assured the Commission that it will ensure that market-

makers exercise their discretion in a manner consistent with their

obligation to price options fairly. The Commission expects that the PCX

will develop objective, quantifiable standards for ensuring that the

market-makers are satisfying those obligations and to surveil for such

compliance. The pilot offers an opportunity for the Commission to

evaluate the Exchange's efforts at surveilling market-maker activities

associated with AOR. Prior to permanent approval, the Commission

expects to review the results of the applied surveillance program. The

Exchange has also stated that it intends to monitor the process by

which imbalance thresholds are established.\18\ The Commission expects

to review the results of the Exchange's surveillance of the

establishment of the imbalance thresholds.

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\18\ See supra note 15.

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Although AOR is likely to greatly improve the opening on PCX, the

Commission believes that the system can and should be improved to

permit participation by non-bookable orders. The Commission does not

view the manual handling of non-bookable orders as the optimal solution

for ensuring that those orders are fairly incorporated into the

opening. It would be preferable for such orders to be electronically

incorporated into an AOR opening. Prior to permanent approval, the

Commission expects the Exchange to develop a workable plan for

incorporation non-bookable orders on AOR.

The Commission finds good cause for approving the proposal, as

amended, prior to the thirtieth day after the date of publication of

notice of filing of the proposed rule change in the Federal Register.

The Commission finds that the proposed rule change is designed to

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

market and a national market system by expediting the opening of option

issues on the Exchange.

The Commission also finds good cause for approving proposed

Amendment No. 3 prior to the thirtieth day after the date of

publication of notice of filing of the amendment in the Federal

Register. The amendment merely proposes to implement AOR on a pilot

basis.\19\ By implementing AOR on a pilot basis, the Exchange can

immediately address difficulties associated with lengthy opening

rotations and study AOR under market conditions while giving the

Commission an opportunity to view the operation of

[[Page 54716]]

AOR under market conditions before approving it permanently.

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\19\ See Amendment No. 3, supra note 7.

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The Commission expects the PCX to study issues related to the

Commission's concerns during the pilot period and to report back to the

Commission at least sixty days prior to seeking permanent approval of

AOR. In addition to issues discussed above, among the issues that the

Exchange should explore are: The effect of AOR on the quality of

customer executions, any effects on existing order execution priority,

and the handling of non-bookable orders.

IV. Solicitation of Comments

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

arguments concerning Amendment No. 3, including whether Amendment No. 3

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 20549-0609. 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 Room. 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-PCX-99-24 and should be

submitted by October 28, 1999.

V. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\20\ that the proposed rule change (SR-PCX-99-24), as amended, is

approved on a pilot basis until October 1, 2000, on an accelerated

basis.

\20\ 15 U.S.C. 78s(b)(2).

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\21\

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\21\ 17 CFR 200.30-3(a)(12).

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Jonathan G. Katz,

Secretary.

[FR Doc. 99-26156 Filed 10-6-99; 8:45 am]

BILLING CODE 8010-01-M