[Federal Register Volume 74, Number 161 (Friday, August 21, 2009)]
[Notices]
[Pages 42350-42355]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-20062]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-60499; File No. SR-CBOE-2009-007]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Amendment No. 1 and Order Granting 
Accelerated Approval to a Proposed Rule Change, as Modified by 
Amendment No. 1 Thereto, Relating to Tied Hedge Transactions

August 13, 2009.

I. Introduction

    On February 13, 2009, the Chicago Board Options Exchange, 
Incorporated (``CBOE'' or the ``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 allow hedging stock, security 
futures, or futures contract positions to be represented currently with 
option facilitations or solicitations in the trading crowd (``tied 
hedge'' orders). The proposed rule change was published for comment in 
the Federal Register on March 2, 2009.\3\ The Commission received one 
comment letter on the proposal.\4\ CBOE responded to the comment letter 
on August 11, 2009.\5\ CBOE filed Amendment No. 1 to the proposed rule 
change on August 11, 2009. This notice and order provides notice of 
filing of Amendment No. 1 to the proposed rule change, and grants 
accelerated approval to the proposed rule change, as modified by 
Amendment No. 1.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 59435 (February 23, 
2009), 74 FR 9115 (``Notice'').
    \4\ See Letter from Michael J. Simon, Secretary, International 
Securities Exchange, LLC (``ISE''), to Nancy M. Morris, Secretary, 
Commission dated March 25, 2009 (``ISE Letter'').
    \5\ See Letter from Jennifer M. Lamie, Assistant General 
Counsel, CBOE, to Elizabeth M. Murphy, Secretary, Commission dated 
August 11, 2009 (``CBOE Letter'').
---------------------------------------------------------------------------

II. Description of the Proposal

    CBOE Rule 6.74 generally sets forth the procedures by which a floor 
broker may cross an order with a contra-side order. Transactions 
executed pursuant to Rule 6.74 are subject to the restrictions of 
paragraph (e) of Rule 6.9, Solicited Transactions, which prohibits 
trading based on knowledge of imminent undisclosed solicited 
transactions (commonly referred to as ``anticipatory hedging'').

A. Anticipatory Hedging Rule

    CBOE Rule 6.9, adopted in 1994, was originally designed to preserve 
the right to solicit orders in advance of submitting a proposed trade 
to the crowd, while at the same time assuring that orders that are the 
subject of a solicitation are exposed to the auction market in a 
meaningful way.\6\ In addition to requiring disclosure of orders and 
clarifying the priority principles applicable to solicited 
transactions, CBOE Rule 6.9 provides that it is inconsistent with just 
and equitable principles of trade for any member or associated person 
who has knowledge of all the material terms of an original order and a 
solicited order (including a facilitation order) that matches the 
original order's price to enter an order to buy or sell an option of 
the same class as any option that is the subject of the solicitation 
prior to the time the original order's terms are disclosed to the crowd 
or the execution of the solicited transaction can no longer reasonably 
be considered imminent. This prohibition extends to orders to buy or 
sell the underlying security or any ``related instrument.''\7\
---------------------------------------------------------------------------

    \6\ According to the Exchange, if the orders that comprise a 
solicited transaction are not suitably exposed to the order 
interaction process on the CBOE floor, the execution of such orders 
would not be consistent with CBOE rules designed to promote order 
interaction in an open-outcry auction. For example, CBOE Rule 6.43, 
Manner of Bidding and Offering, requires bids and offers to be made 
at the post by public outcry, and Rule 6.74 imposes specific order 
exposure requirements on floor brokers seeking to cross buy orders 
with sell orders. See Notice, supra note 3, at 9116.
    \7\ CBOE Rule 6.9(e) defines ``related instrument'' to mean ``in 
reference to an index option, an order to buy or sell securities 
comprising ten percent or more of the component securities in the 
index or an order to buy or sell a futures contract on any 
economically equivalent index. With respect to an SPX option, an OEX 
option is a related instrument, and vice versa.''
---------------------------------------------------------------------------

B. Proposed Exception to Anticipatory Hedging Rule

    In order to address CBOE's perceived concerns associated with 
increased volatility and decreased liquidity and to more effectively 
compete with the over-the-counter market,\8\ the Exchange is now 
proposing to adopt a limited exception to its anticipatory hedging 
restrictions that would permit the representation of hedging stock 
positions in conjunction with option orders, including complex orders, 
in the options trading crowd (a ``tied hedge'' transaction). The 
Exchange believes this limited exception would be consistent with the 
original design of CBOE Rule 6.9(e), but would set forth a more 
practicable approach that would facilitate hedging in today's trading 
environment while still encouraging meaningful competition among 
upstairs and floor traders.\9\
---------------------------------------------------------------------------

    \8\ See Notice, supra note 3, at 9116 (discussing CBOE's 
rationale behind its proposal).
    \9\ See id. at 9120.
---------------------------------------------------------------------------

    With a tied hedge transaction, Exchange members would be permitted 
to first hedge an option and then forward the option order and the 
hedging position to an Exchange floor broker with instructions to 
represent the option order together with the hedging position to the 
options trading crowd. Under the proposal, the original option order 
must be within designated size parameters, which would be determined by 
the Exchange and could not be smaller than 500 contracts. In addition, 
the original option order must be in a

[[Page 42351]]

class designated as eligible for a tied hedge transaction. Eligible 
hedging positions would be determined by the Exchange for each eligible 
class and may include (i) the same underlying stock applicable to the 
option order, (ii) a security future overlying the same stock 
applicable to the option order, or (iii) in reference to an option on 
an index, exchange-traded fund (``ETF''), or options on HOLding Company 
Depository ReceiptS (``HOLDRS''), a related instrument may be used as a 
hedge. A ``related instrument'' would mean, in reference to an index 
option, securities comprising ten percent or more of the component 
securities in the index or a futures contract on any economically 
equivalent index applicable to the option order. With respect to SPX, 
OEX would be an economically equivalent index, and vice versa.\10\ A 
``related instrument'' would mean, in reference to an ETF or HOLDRS 
option, a futures contract on any economically equivalent index 
applicable to the ETF or HOLDRS underlying the option order.\11\
---------------------------------------------------------------------------

    \10\ The proposed definition of a ``related instrument'' with 
respect to an index option is modeled after the definition that 
currently applies under Rule 6.9(e).
    \11\ For example, a tied hedge order involving options on the 
iShares Russell 2000 Index ETF might involve a hedge position in the 
underlying ETF, security futures overlying the ETF, or futures 
contracts overlying the Russell 2000 Index.
---------------------------------------------------------------------------

    The proposal would require that the entire hedging position, which 
could not exceed the options order on a delta basis, be brought without 
undue delay to the trading crowd, announced to the trading crowd 
concurrently with the option order, offered to the crowd in its 
entirety, and offered at the execution price received by the member or 
member organization introducing the order to any in-crowd market 
participant who has established parity or priority for the related 
options.
    In-crowd market participants that participate in the option 
transaction must participate in the hedging position on a proportionate 
basis and would not be permitted to prevent the option transaction from 
occurring by giving a competing bid or offer for one component of the 
tied hedge order.
    In addition, the proposal would require that, prior to entering 
tied hedge orders on behalf of customers, the member must deliver to 
the customer a one-time written notification informing the customer 
that its order may be executed using the Exchange's tied hedge 
procedures. A member also would be required to create an electronic 
record of the tied hedge order in a form and manner prescribed by the 
Exchange.

C. Amendment No. 1

    In Amendment No. 1, the Exchange reflected in rule text the 
priority treatment applicable to all tied hedge transactions 
(regardless of whether the original order is a simple order or a 
complex order) by clarifying that such transactions will be treated the 
same as complex orders for purposes of CBOE's open outcry allocation 
and reporting procedures.\12\ CBOE also clarified that where an 
original order is a simple order, the initial execution of the option 
leg will not qualify for the ``complex trade'' exception from the Plan 
for the Purpose of Creating and Operating an Intermarket Option Linkage 
(``Options Linkage Plan'').\13\ The text of Amendment No. 1 is 
available on the Exchange's Web site (http://www.cboe.org/Legal), at 
the Exchange's Office of the Secretary, and at the Commission's Public 
Reference Room.
---------------------------------------------------------------------------

    \12\ The Commission notes that, while a tied hedge may be 
treated the same as a complex order for purposes of CBOE's intra-
market priority, an original single-sided customer order would not 
otherwise constitute a complex order solely by virtue of being 
packaged into a tied hedge transaction. Accordingly, when a single-
sided customer order is packaged into a tied hedge transaction, the 
execution of the option leg will not qualify for the ``complex 
trade'' exception from the Options Linkage Plan.
    \13\ On July 28, 2000, the Commission approved the Options 
Linkage Plan as a national market system plan for the purpose of 
creating and operating an intermarket options market linkage 
proposed by the American Stock Exchange LLC (n/k/a NYSE Amex LLC), 
CBOE, and International Securities Exchange, LLC (``ISE''). See 
Securities Exchange Act Release No. 43086 (July 28, 2000), 65 FR 
48023 (August 4, 2000) (File No. 4-429). Subsequently, Philadelphia 
Stock Exchange, Inc. (n/k/a NASDAQ OMX PHLX, Inc.), Pacific 
Exchange, Inc. (n/k/a NYSE Arca), Boston Stock Exchange, Inc. (n/k/a 
NASDAQ OMX BX, Inc.), and The NASDAQ Stock Market LLC joined the 
Options Linkage Plan. See Securities Exchange Act Release Nos. 43573 
(November 16, 2000), 65 FR 70851 (November 28, 2000) (File No. 4-
429); 43574 (November 16, 2000), 65 FR 70850 (November 28, 2000) 
(File No. 4-429); 49198 (February 5, 2004), 69 FR 7029 (February 12, 
2004) (File No. 4-429); and 57545 (March 21, 2008), 73 FR 16394 
(March 27, 2008) (File No. 4-429). The Commission recently approved 
a new national market system plan regarding intermarket options 
linkage, the Options Order Protection and Locked/Crossed Market 
Plan, which carries over the complex order exception from the 
Options Linkage Plan. See Securities Exchange Act Release No. 60405 
(July 30, 2009), 74 FR 39362 (August 6, 2008) (File No. 4-546). See 
also Securities Exchange Act Release No. 60187 (June 29, 2009), 74 
FR 32664 (July 8, 2009) (SR-CBOE-2009-040) (notice of filing of 
CBOE's new Options Linkage rules).
---------------------------------------------------------------------------



III. Summary of Comments and CBOE Response

    The Commission received one comment on the proposed rule change 
from the ISE.\14\ CBOE submitted a letter to the Commission responding 
to ISE's comment letter.\15\
---------------------------------------------------------------------------

    \14\ See ISE Letter, supra note 4.
    \15\ See CBOE Letter, supra note 5.
---------------------------------------------------------------------------

    ISE argued that the proposed tied hedge transaction was similar to 
front-running and may disadvantage the trading crowd competing for the 
order in the auction process as well as the order being executed.\16\ 
ISE believed that CBOE's proposal would allow a member with knowledge 
of a pending transaction to have an advantage over others in the 
auction market process, which could result in less competition and 
worse prices for customers.\17\
---------------------------------------------------------------------------

    \16\ See ISE Letter, supra note 4, at 1.
    \17\ See id. at 1.
---------------------------------------------------------------------------

    In response, CBOE explained that it did not believe a firm that 
establishes a hedge position pursuant to the proposal would be taking 
advantage of material, nonpublic information as contemplated by the 
front-running prohibitions.\18\ Rather, CBOE noted that its proposal 
provides the options trading crowd with the same access to a hedge as 
the solicited party, thereby allowing the crowd to compete on the same 
terms, because the tied hedge position would be required to be brought 
without undue delay to the trading crowd and announced concurrently 
with the option order, offered to the crowd in its entirety, and 
offered at the execution price received by the member to any in-crowd 
market participant who establishes parity or priority for the related 
option order.\19\ The Exchange asserted its belief that the tied hedge 
proposal may result in narrow spreads and improved customer prices.\20\
---------------------------------------------------------------------------

    \18\ See CBOE Letter, supra note 5, at 2-3.
    \19\ See id. at 3.
    \20\ See id. at note 5.
---------------------------------------------------------------------------

    In addition, ISE expressed concern that the proposed hedging 
activity may cause movement in the price of the underlying security and 
consequently the option, resulting in a worse price for the options 
customer.\21\ In response, CBOE explained that its proposal attempts to 
address this concern by providing a mechanism to facilitate hedging 
that it believes will not be detrimental to the options orders being 
hedged nor the auction market.\22\ CBOE noted that participants will 
continue to be governed by, among other things, their best execution 
responsibilities.
---------------------------------------------------------------------------

    \21\ See ISE Letter, supra note 4, at 1-2.
    \22\ See CBOE Letter, supra note 5, at 3.
---------------------------------------------------------------------------

    ISE further opined that CBOE's proposal, because it does not permit 
the trading crowd to execute the options order without taking a 
proportionate share of the hedge, could increase internalization and 
lead to less vigorous

[[Page 42352]]

competition for price improvement.\23\ ISE believed that requiring the 
crowd to take the hedge at the same price will prevent the crowd from 
giving the options customer the best price for its options transaction. 
In response, CBOE stated that the requirement to participate in the 
entire package is designed to keep the initiating member and in-crowd 
market participants on equal footing.\24\ CBOE further argued that, 
since the trading crowd will have access to the same downside 
protection as the solicited party that executed the hedge position, the 
crowd should be willing to provide price improvement to the tied hedge 
order just as much as, if not more than, any other facilitation/
solicited order.\25\
---------------------------------------------------------------------------

    \23\ See ISE Letter, supra note 4, at 2.
    \24\ See CBOE Letter, supra note 5, at 3.
    \25\ See id.
---------------------------------------------------------------------------

    ISE also inquired whether CBOE's proposal would prohibit a firm 
from taking securities from inventory.\26\ CBOE clarified that the tied 
hedge procedure would not permit a firm to take hedging securities from 
inventory and stated that, in contrast, the proposal explicitly 
requires that the hedge position be bought or sold following the 
receipt of an option order and prior to announcing such order in the 
trading crowd.\27\
---------------------------------------------------------------------------

    \26\ ISE Letter, supra note 4, at 2.
    \27\ See CBOE Letter, supra note 5, at 3.
---------------------------------------------------------------------------

    ISE noted the possibility under CBOE's proposal that a customer 
order would not be executable because of market conditions in any of 
the non-CBOE markets in the underlying.\28\ In response, CBOE noted 
that it recognized that market conditions in any of the non-CBOE 
market(s) may prevent the execution of the non-options leg(s) at the 
price(s) agreed upon. CBOE stated that in the event that the conditions 
in the non-CBOE market continue to prevent the execution of the non-
option leg(s) at the agreed price(s), the trade representing the 
options leg(s) of the tied hedge transaction, as with any other complex 
order, may ultimately be cancelled in accordance with CBOE's existing 
rules.\29\
---------------------------------------------------------------------------

    \28\ See ISE Letter, supra note 4, at 2.
    \29\ See CBOE Letter, supra note 5, at 6.
---------------------------------------------------------------------------

    In addition, ISE expressed concern regarding the treatment of 
CBOE's tied-hedge transactions under the trade-through protections 
contained in the Options Linkage Plan as well as the contingent trade 
exemption under Regulation NMS.\30\ ISE noted that tied-hedge 
transactions are not, by default, complex orders unless they meet the 
definition of a ``complex trade'' under the uniform linkage rules. ISE 
also commented that tied hedge transactions in which the original 
customer order is a non-complex order for a single options series that 
it would not qualify for the qualified contingent trade exception to 
Rule 611(a) of Regulation NMS. ISE also opined that the exception for 
complex orders and exemption for qualified contingent trades require 
that the trades involve multiple legs for the same account, whereas a 
tied hedge would likely include components for multiple accounts of 
unrelated parties.
---------------------------------------------------------------------------

    \30\ See ISE Letter, supra note 4, at 3.
---------------------------------------------------------------------------

    CBOE responded by noting that an in-crowd participant would be 
trading all legs of a tied hedge package like any other complex order, 
and, accordingly, it believes that contra-side executions would qualify 
as complex trades.\31\ Further, in Amendment No. 1, CBOE clarified that 
where an original order is a simple order, the execution of the option 
leg will not qualify for the ``complex trade'' exception from the 
Options Linkage Plan.
---------------------------------------------------------------------------

    \31\ See CBOE Letter, supra note 5, at 4.
---------------------------------------------------------------------------

    Further, ISE stated its belief that a tied hedge differs from a 
complex order in that a stock-option order requires the stock leg to be 
on the opposite side of the options leg, whereas under CBOE's proposal 
the stock leg in the tied hedge transaction would be on the same side 
of the market as the options leg.\32\ CBOE's response confirmed that 
under the proposal the stock leg of the tied hedge package would be on 
the opposite side from the option leg.\33\
---------------------------------------------------------------------------

    \32\ See ISE Letter, supra note 4, at 3.
    \33\ See CBOE Letter, supra note 5, at 5.
---------------------------------------------------------------------------

    ISE also argued that CBOE should explore further the mechanics of 
how tied hedge transactions would be executed on CBOE.\34\ In 
particular, ISE inquired as to whether and how participants would 
execute the hedge in sub-penny increments. ISE also asked whether CBOE 
intended to impose any limit on who is permitted to participate in the 
auction for the order.\35\
---------------------------------------------------------------------------

    \34\ See ISE Letter, supra note 4, at 3.
    \35\ See id. at 4.
---------------------------------------------------------------------------

    CBOE responded that, as discussed in the Notice, tied hedge 
transactions would be treated the same as any other complex order with 
priority afforded in accordance with the Exchange's existing open 
outcry allocation and reporting procedures for complex orders.\36\ In 
addition, CBOE stated that tied hedge transactions would also be 
subject to the existing national best bid or offer (``NBBO'') trade-
through requirements for options and stock, as applicable. CBOE noted 
that it discussed in the Notice that market conditions in any of the 
non-CBOE markets may prevent the execution of the non-options leg(s) at 
the price(s) agreed upon and in such case the options leg(s) of the 
tied hedge transaction, as with any other complex order, may ultimately 
be cancelled in accordance with CBOE's existing rules.\37\ CBOE further 
explained that in scenarios where the hedge would result in a net sub-
penny price, the hedge would be executed with orders at multiple price 
points necessary to receive the same overall net price in much the same 
manner that the original stock hedge was obtained.\38\
---------------------------------------------------------------------------

    \36\ See CBOE Letter, supra note 5, at 5.
    \37\ See id.
    \38\ See id.
---------------------------------------------------------------------------

IV. Discussion

    After careful review of the proposed rule change, as amended, the 
comment letter, and CBOE's response to the comment letter, 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.\39\ In particular, the 
proposal is consistent with Section 6(b)(5) of the Act,\40\ which 
requires, among other things, that the rules of a national securities 
exchange be designed 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, and not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers. 
Further, the Commission believes that CBOE has sufficiently responded 
to the issues raised by the ISE in its comment letter.
---------------------------------------------------------------------------

    \39\ In approving this rule change, the Commission notes that it 
has considered the proposed rule's impact on efficiency, 
competition, and capital formation. See 15 U.S.C. 78c(f).
    \40\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    In the Notice, CBOE justified its proposal by explaining that 
changes in the marketplace have caused it to re-evaluate the 
effectiveness and efficiency of its anticipatory hedging rule, as well 
as its previous objections to an exception proposed by another exchange 
for its proposed equivalent rule in 2003.\41\ When the prohibition on

[[Page 42353]]

anticipatory hedging was originally adopted, CBOE believed that it was 
necessary to prevent members and associated persons from using 
undisclosed information about imminent solicited option transactions to 
trade the relevant option or any closely-related instrument in advance 
of persons represented in the relevant options crowd. The Exchange now 
believes that increased volatility in the markets, as well as the 
advent of penny trading in underlying stocks and resultant decreased 
liquidity at the top of each underlying market's displayed national 
best bid or offer, has made it increasingly difficult for members and 
member organizations to assess ultimate execution prices and the extent 
of available stock to hedge related options facilitation/solicitation 
activities, and to manage that market risk.\42\ These circumstances may 
make it more difficult to obtain a hedge, to quote orders, and to 
achieve executions. In addition, the Exchange believes that market-
makers' trading strategies have evolved to focus less on delta risk and 
more on volatility.\43\ The proposed tied hedge transaction procedures 
are intended to reflect CBOE's perceived shift by members toward a 
volatility trading strategy, and to make it more desirable for market 
makers to compete for orders that are exposed through the solicitation 
process. The Exchange further expects its proposal to allow members to 
hedge an original order and thus minimize delta risk and, thus, should 
provide an opportunity for members to provide customers with tighter 
quotes to the extent they are able to use the tied hedge procedure to 
better hedge and compete for orders.\44\
---------------------------------------------------------------------------

    \41\ CBOE's proposed exception is similar to an exception that 
had been proposed in 2003 by the Philadelphia Stock Exchange 
(``Phlx''). See Securities Exchange Act Release No. 48875 (December 
4, 2003), 68 FR 70072 (December 16, 2003) (SR-Phlx-2003-75). At the 
time of the Phlx proposal, which was withdrawn, CBOE commented that 
the proposal should not be approved unless certain amendments were 
made. For example, CBOE suggested that the tied hedge procedures 
should be limited to scenarios where the order cannot be satisfied 
by the displayed national best bid or offer (``NBBO'') or, for 
similar reasons, the order is of a significantly larger than average 
size. See letters from Edward J. Joyce, President and Chief 
Operating Officer, CBOE, to Jonathan G. Katz, Secretary, Commission, 
dated January 14, 2004 (``CBOE Letter I'') and May 20, 2004 (``CBOE 
Letter II'').
    \42\ See Notice, supra note 3, at 9116.
    \43\ See id. at 9116-17.
    \44\ See id. at 9119.
---------------------------------------------------------------------------

    Minimum Size. Under the proposal, the original option order must be 
within designated tied hedge eligibility size parameters, which could 
not be smaller than 500 contracts.\45\ The minimum order size would 
apply to an individual original order, and multiple original orders 
could not be aggregated to satisfy the requirement.\46\ The Commission 
believes that this requirement is reasonable and should limit use of 
the tied hedge procedures to institutional customers who are in a 
better position to understand the mechanics of the process and who may 
benefit from the ability to execute a facilitating hedge on CBOE.\47\
---------------------------------------------------------------------------

    \45\ The designated classes and minimum order size applicable to 
each class would be communicated to the membership via Regulatory 
Circular. For example, the Exchange could determine to make the tied 
hedge transaction procedures available in options class XYZ for 
orders of 1000 contracts or more. Such a determination would be 
announced via Regulatory Circular, which would include a cumulative 
list of all classes and corresponding sizes for which the tied hedge 
procedures are available.
    \46\ In determining whether an individual original order 
satisfies the eligible order size requirement, any complex order 
must contain one leg alone that is for the eligible order size or 
greater. This approach to the eligible order size requirement for 
complex orders is analogous to Rule 6.74(d)(iii), which provides 
that a complex order must contain one leg alone that is for the 
eligible order size or greater to be eligible for an open outcry 
crossing entitlement.
    \47\ As discussed above supra note 41, in commenting on the 
prior Phlx proposal, CBOE suggested that the tied hedge procedures 
be limited to scenarios where the order cannot be satisfied by the 
NBBO or, for similar reasons, the order is of a significantly larger 
than average size. CBOE's reasoning was that there may not be as 
much benefit to delaying the representation and execution of smaller 
orders that may be immediately fillable or executed more quickly by 
sending an order to the options crowd (as opposed to tying up such 
an order with stock). See CBOE Letter II, supra note 41, at 3-4. The 
Exchange now believes the decreased liquidity available at the NBBO, 
the frequency with which quotes may flicker, and differing costs 
associated with accessing liquidity on various markets, as well as 
for ease of administration, that its proposed 500 contract minimum 
is sufficient to address these considerations. See Notice, supra 
note 3, at 9117.
---------------------------------------------------------------------------

    Written Notification. The proposal also requires that, prior to 
entering tied hedge orders on behalf of customers, the CBOE member must 
deliver to its customer a one-time written notification informing the 
customer that his order may be executed using the Exchange's tied hedge 
procedures and disclosing the terms and conditions contained in the 
proposed rule. Given the minimum size requirement of 500 contracts per 
order, the Exchange believes that use of the tied hedge procedures will 
generally consist of orders for the accounts of institutional or 
sophisticated, high net worth investors.\48\ Given the target audience 
and the considerable minimum size requirement, the Commission believes 
that a one-time notification is sufficient and is consistent with 
similar notification requirements on other exchanges.\49\
---------------------------------------------------------------------------

    \48\ See Notice, supra note 3, at 9117.
    \49\ See ISE Rule 716(e)(3) (Solicited Order Mechanism).
---------------------------------------------------------------------------

    Eligible Hedging Positions. The proposed rule would require that 
the hedging position associated with the tied hedge order be composed 
of a position that is designated as eligible for a tied hedge 
transaction. Eligible hedging positions would be determined by the 
Exchange for each eligible class and may include (i) the same 
underlying stock applicable to the option order, (ii) a security future 
overlying the same stock applicable to the option order, or (iii) in 
reference to an option on an index, ETF or HOLDRS, a ``related 
instrument'' (as described above). For example, for options overlying 
XYZ stock, the Exchange may determine to designate the underlying XYZ 
stock or XYZ security futures or both as eligible hedging 
positions.\50\ The Commission believes that this provision will provide 
for a definitive hedge that is easily understood by other market 
participants, and consequently should allow members who may be 
considering participating in a tied hedge order to evaluate more 
readily the risk associated with the option in light of the hedge.
---------------------------------------------------------------------------

    \50\ As with designated classes and minimum order size, the 
eligible hedging positions applicable to each class would be 
communicated to the membership via Regulatory Circular, which would 
include a cumulative list of all classes and corresponding sizes for 
which the tied hedge procedures are available.
---------------------------------------------------------------------------

    Presentation to the Crowd. The proposal would require that the 
entire hedging position be brought promptly and without ``undue delay'' 
to the trading crowd. In addition, the proposal would require that the 
hedging position be announced to the trading crowd concurrently with 
the option order, offered to the crowd in its entirety, and offered at 
the execution price received by the member or member organization 
introducing the order to any in-crowd market participant who has 
established parity or priority for the related options. In-crowd market 
participants that participate in the option transaction would be 
required to participate in the hedging position on a proportionate 
basis \51\ and would not be permitted to prevent the option transaction 
from occurring by giving a competing bid or offer for one component of 
the tied hedge order. The Commission believes that these requirements 
are reasonably designed to encourage access to and participation by the 
trading crowd in the tied hedge transaction.
---------------------------------------------------------------------------

    \51\ For example, if an in-crowd market participant's allocation 
is 100 contracts out of a 500 contract option order (\1/5\), the 
same in-crowd market participant would trade 10,000 shares of a 
50,000 stock hedge position tied to that option order (\1/5\).
---------------------------------------------------------------------------

    Further, while delta estimates may vary slightly, the introducing 
member would be required to assume a hedging position that does not 
exceed the equivalent size of the options order on a delta basis.\52\ 
For example, with a tied

[[Page 42354]]

hedge transaction involving the purchase of 50,000 shares of XYZ stock 
and the sale of 500 XYZ call contracts with a delta of 100, the order 
would be considered fully hedged by 50,000 shares of stock. The 
Commission believes that prohibiting a tied hedge order from being 
deliberately over-hedged should ensure that such transactions represent 
bona fide hedging activity and should not deter the willingness of the 
options crowd to participate in the order.
---------------------------------------------------------------------------

    \52\ In the Notice, the Exchange notes that there may be 
scenarios were the introducing member purchases (sells) less than 
the delta, e.g., when there is not enough stock is available to buy 
(sell) at the desired price. In such scenarios, the introducing 
member would present the stock that was purchased (sold) and share 
it with the in-crowd market participants on equal terms. This risk 
of obtaining less than a delta hedge is a risk that exists under the 
current rules because of the uncertainty that exists when market 
participants price an option and have to anticipate the price at 
which they will be able to obtain a hedge. The proposed tied hedge 
procedures are designed to help reduce this risk, but the initiating 
member may still be unable to execute enough stock at the desired 
price. See Notice, supra note 3, at 9118.
---------------------------------------------------------------------------

    Priority. The Exchange has not proposed any special priority 
provisions applicable to tied hedge transactions. Tied hedge 
transactions would be treated the same as complex orders (regardless of 
whether the original order was a simple or complex order) for purposes 
of CBOE's intra-market priority.\53\ The Commission notes that while an 
original single-sided customer order would not constitute a complex 
order, particularly for purposes of the complex trade exception to the 
Options Linkage Plan, CBOE's proposal to treat such order when it is 
packaged into a tied hedge transaction the same as a complex order for 
the limited purpose of determining CBOE's intra-market priority is 
reasonable. Among other things, because a tied hedge transaction would 
be presented to the crowd as a package and crowd participants could 
only trade with both the order and the hedge on a proportionate basis, 
such treatment is appropriate under the circumstances with respect to 
CBOE's intra-market priority.
---------------------------------------------------------------------------

    \53\ Generally, a complex order may be expressed in any 
increment and executed at a net debit or credit price with another 
member without giving priority to equivalent bids (offers) in the 
individual series legs that are represented in the trading crowd or 
in the public customer options limit order book provided at least 
one leg of the order betters the corresponding bid (offer) in the 
public customer options limit order book. For stock-option orders 
and security future-option orders, this means that the options leg 
of the order has priority over bids (offers) of the trading crowd 
but not over bids (offers) in the public customer options limit 
order book. In addition, for complex orders with non-option leg(s), 
such as stock-option orders, a bid or offer is made and accepted 
subject to certain other conditions, including that the options 
leg(s) may be cancelled at the request of any member that is a party 
to the transaction if market conditions in any non-CBOE market(s) 
prevent the execution of the non-options leg(s) at the agreed 
price(s). See, e.g., CBOE Rules 6.42, Minimum Increments for Bids 
and Offers, 6.45, Priority of Bids and Offers--Allocation of Trades, 
6.45A(b), Allocation of Orders Represented in Open Outcry (for 
equity options), 6.45B(b), Allocation of Orders Represented in Open 
Outcry (for index options and options on ETFs), 6.48, Contract Made 
on Acceptance of Bid or Offer, and 6.74. Any crossing participation 
entitlement would also apply to the tied hedge procedures in 
accordance with Rule 6.74(d).
---------------------------------------------------------------------------

    To the extent applicable and available, tied hedge transactions may 
also qualify for existing NBBO trade-through exceptions for options and 
stock, including, for example, the complex trade exception to the 
Options Linkage Plan (which would apply when the original order is a 
complex order) \54\ and the qualified contingent trade exception to 
Rule 611(a) for the stock component when an in-crowd participant 
participates in the transaction.\55\
---------------------------------------------------------------------------

    \54\ Where the original order is a simple order, the execution 
of the option leg will not qualify for the ``complex trade'' 
exception from the Options Linkage Plan. Thus, a member could not 
tie a customer single-sided options order to a hedging position for 
the sole purpose of availing the tied hedge package to the complex 
trade exception from the Options Linkage Plan. A ``complex trade'' 
is defined as: (i) The execution of an order in an option series in 
conjunction with the execution of one or more related orders in 
different option series in the same underlying security occurring at 
or near the same time in a ratio that is equal to or greater than 
one-to-three (.333) and less than or equal to three-to-one (3.0) and 
for the purpose of executing a particular investment strategy; or 
(ii) the execution of a stock option order to buy or sell a stated 
number of units of an underlying stock or a security convertible 
into the underlying stock (``convertible security'') coupled with 
the purchase or sale of option contract(s) on the opposite side of 
the market representing either (A) the same number of units of the 
underlying stock or convertible security, or (B) the number of units 
of the underlying stock or convertible security necessary to create 
a delta neutral position, but in no case in a ratio greater than 8 
option contracts per unit of trading of the underlying stock or 
convertible security established for that series by the Options 
Clearing Corporation. See paragraph (4) of CBOE Rule 6.80, 
Definitions (applicable to Options Linkage), and subparagraph (b)(7) 
to CBOE Rule 6.83, Order Protection. The new Options Linkage Plan 
was recently approved by the Commission and carries over the complex 
order exception. See Securities Exchange Act Release No. 60405 (July 
30, 2009) (File No. 4-546). See also Securities Exchange Act Release 
No. 60187 (June 29, 2009), 74 FR 32664 (July 8, 2009) (notice of 
filing of CBOE's new Options Linkage rules).
    \55\ A ``qualified contingent trade'' is defined as a 
transaction consisting of two or more component orders, executed as 
agent or principal, where: (i) At least one component order is in an 
NMS stock; (ii) all components are effected with a product or price 
contingency that either has been agreed to by the respective 
counterparties or arranged for by a broker-dealer as principal or 
agent; (iii) the execution of one component is contingent upon the 
execution of all other components at or near the same time; (iv) the 
specific relationship between the component orders (e.g., the spread 
between the prices of the component orders) is determined at the 
time the contingent order is placed; (v) the component orders bear a 
derivative relationship to one another, represent different classes 
of shares of the same issuer, or involve the securities of 
participants in mergers or with intentions to merge that have been 
announced or since cancelled; and (vi) any trade-throughs caused by 
the execution of an order involving one or more NMS stocks (each an 
``Exempted NMS Stock Transaction'') is fully hedged (without regard 
to any prior existing position) as a result of the other components 
of the contingent trade. See Securities Exchange Act Release No. 
57620 (April 4, 2008), 73 FR 19271 (April 9, 2008).
---------------------------------------------------------------------------

    Further, when a tied hedge transaction is executed, it is possible 
that market conditions in a non-CBOE market might prevent the execution 
of the non-options leg(s) at the price(s) agreed upon. In this event, 
the trade representing the options leg(s) of the tied hedge transaction 
may ultimately be cancelled in accordance with CBOE's existing 
rules.\56\
---------------------------------------------------------------------------

    \56\ See paragraph (b) to CBOE Rule 6.48. The Exchange notes 
that, in the event of a cancellation, members may be exposed to the 
risk associated with holding the hedge position.
---------------------------------------------------------------------------

    The following example, which CBOE included in the Notice,\57\ 
illustrates the mechanics of a tied hedge transaction:
---------------------------------------------------------------------------

    \57\ See Notice, supra note 3, at 9119-20.
---------------------------------------------------------------------------

    <bullet> The CBOE member initiates a tied hedge based on either a 
simple or complex original customer order. For example, in a simple 
original order, the introducing member receives a customer order to buy 
500 XYZ call options, which has a delta of 100. The introducing member 
then purchases 50,000 shares of XYZ stock on the NYSE for an average 
price of $25.03 per share. Once the stock is executed on the NYSE, the 
introducing member, without undue delay, announces the 500 contract 
option order along with the 50,000 share tied stock hedge at $25.03 per 
share to the CBOE trading crowd. For a complex original order, the 
introducing member receives a customer stock-option order to buy 500 
XYZ call options and sell 50,000 shares of XYZ stock. The introducing 
member purchases 50,000 shares of XYZ stock on the NYSE for an average 
price of $25.03 per share. Once the stock is executed on the NYSE, the 
introducing member, without undue delay, announces the tied hedge 
package to the trading crowd.
    <bullet> The in-crowd market participants would have an opportunity 
to provide competing quotes for the tied hedge package (but not for the 
individual component legs of the package).
    <bullet> The option order and hedging stock would be allocated 
among the in-crowd market participants that established priority or 
parity at that price, including the initiating member, in accordance 
with the allocation algorithm applicable to the options class, with the 
options leg being executed and reported on CBOE and the stock leg being 
executed and

[[Page 42355]]

reported on the stock market specified by the initiating member.\58\
---------------------------------------------------------------------------

    \58\ For example, the introducing member might trade 40% 
pursuant to an open outcry crossing entitlement (200 options 
contracts and 20,000 shares of stock) and the remaining balance 
might be with three different market makers that each participated 
on 20% of the order (100 options contracts and 10,000 shares of 
stock per market maker).
---------------------------------------------------------------------------

    <bullet> The execution of the options leg would have to satisfy 
CBOE's intra-market priority rules for complex orders (including that 
the execution price may not be outside the CBOE BBO).
    <bullet> Where the customer order is a complex order (not a simple 
order), the tied hedge transaction may qualify as a ``complex trade'' 
under the Options Linkage Plan in which case the execution of the 500 
option contracts with the market participants would not be subject to 
the NBBO for the particular option series.
    <bullet> If the crowd participates in the tied hedge transaction, 
the equities portion of the trade may qualify as a ``qualified 
contingent trade'' under Regulation NMS. For example, if the crowd 
takes an equivalent share representing 20,000 shares of stock (from the 
original 50,000 shares), the market participants would not be subject 
to the NBBO for the 20,000 shares of underlying XYZ stock that they 
execute.
    <bullet> The execution of stock would have to satisfy the intra-
market priority rules of the non-CBOE market(s) where the stock is to 
be executed.
    The Commission believes that CBOE has adequately described the 
mechanics of a proposed tied hedge order, and that the priority 
treatment afforded to a tied hedge transaction is appropriate and 
consistent with CBOE's existing priority rules.

V. Accelerated Approval

    The Commission finds good cause, pursuant to Section 19(b)(2) of 
the Act,\59\ for approving the proposed rule change, as modified by 
Amendment No. 1, prior to the thirtieth day after publication of notice 
of filing of Amendment No. 1 in the Federal Register. In Amendment No. 
1, the Exchange revised the proposed rule text to clarify that all tied 
hedge transactions (regardless of whether the original order was a 
simple order or a complex order such as a spread, straddle, 
combination, or stock-option order) will be treated as complex for 
purposes of CBOE's open outcry allocation and reporting procedures. 
This treatment of tied hedge transactions was described by CBOE in the 
Notice.\60\ CBOE now proposes to reflect this priority provision in the 
rule text for the sake of clarity.
---------------------------------------------------------------------------

    \59\ 15 U.S.C. 78s(b)(2). Pursuant to Section 19(b)(2) of the 
Act, the Commission may not approve any proposed rule change, or 
amendment thereto, prior to the thirtieth day after the date of 
publication of the notice thereof, unless the Commission finds good 
cause for so doing.
    \60\ See Notice, supra note 3, at 9119.
---------------------------------------------------------------------------

    CBOE also specified in the proposed rule text that the option and 
stock legs of a tied hedge transaction may qualify for various NBBO 
trade-through exceptions but, where the original order is a simple 
order, the execution of the option leg will not qualify for the 
``complex trade'' exception from the Options Linkage Plan.\61\ 
Accordingly, to the extent that a single-sided customer order was 
packaged to create a tied hedge transaction, such tied hedge would not 
qualify as a complex order for purposes of the Options Linkage Plan.
---------------------------------------------------------------------------

    \61\ This description by CBOE represents a change from the 
Notice, in which CBOE indicated all tied hedge transactions 
(regardless of whether the original order was a simple or complex 
order) would be treated as complex orders, and thus may qualify for 
the complex trade exception to the Options Linkage Plan. See 
Amendment No. 1.
---------------------------------------------------------------------------

    The changes proposed in Amendment No. 1, discussed above, seek to 
clarify the operation of the proposal, particularly with respect to the 
priority rules applicable to a tied hedge transaction, and do not 
differ materially from the proposal as noticed in the Federal Register 
on March 2, 2009. Accordingly, the Commission finds that good cause 
exists to approve the proposed rule change, as modified by Amendment 
No. 1, on an accelerated basis.

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether Amendment No. 1 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

    <bullet> Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
    <bullet> Send an e-mail to <a href="/cdn-cgi/l/email-protection#4230372e276f212d2f2f272c3631023127216c252d34"><span class="__cf_email__" data-cfemail="2153544d440c424e4c4c444f5552615244420f464e57">[email protected]</span></a>. Please include 
File No. SR-CBOE-2009-007 on the subject line.

Paper Comments

    <bullet> Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-CBOE-2009-007. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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, on official business 
days between the hours of 10 a.m. and 3 p.m. Copies of such filing also 
will be available for inspection and copying at the principal office of 
the Exchange. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
CBOE-2009-007 and should be submitted on or before September 11, 2009.

VII. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change, as modified by Amendment No. 1, is consistent with the Act 
and the rules and regulations thereunder applicable to a national 
securities exchange.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\62\ that the proposed rule change (SR-CBOE-2009-007), as modified 
by Amendment No. 1, be, and hereby is, approved on an accelerated 
basis.
---------------------------------------------------------------------------

    \62\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\63\
---------------------------------------------------------------------------

    \63\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-20062 Filed 8-20-09; 8:45 am]
BILLING CODE 8010-01-P


</pre><script data-cfasync="false" src="/cdn-cgi/scripts/5c5dd728/cloudflare-static/email-decode.min.js"></script></body>
</html>