[Federal Register Volume 65, Number 108 (Monday, June 5, 2000)]
[Notices]
[Pages 35683-35686]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-13955]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42835; File No. SR-CBOE-99-10]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the Chicago 
Board Options Exchange, Inc., Relating to Participation Rights for 
Firms Crossing Orders.

May 26, 2000.

I. Introduction

    On March 18, 1999, the Chicago Board Options Exchange, Inc. 
(``CBOE'' 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 amend its rule governing the 
crossing of equity option orders by floor brokers, to give the member 
firm from which an order originates (``originating firm'' a 
participation right in trades that are proposed to be crossed in 
certain circumstances. Notice of the proposed rule change was published 
for comment in the Federal Register on July 16, 1999.\3\ The Commission 
received four comment letters regarding the proposal.\4\ On October 4, 
1999, April 11, 2000, and May 25, 2000, the CBOE filed Amendment Nos. 
1, 2, and 3, respectively, to the proposal.\5\ This order approves the 
proposed rule change, accelerates approval of Amendment Nos. 1, 2, and 
3, and solicits comments from interested persons on those amendments.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 41609 (July 8, 
1999), 64 FR 38494.
    \4\ See Section III below for a description of the comment 
letters.
    \5\ The substantive modifications made by these amendments are 
incorporated in the description of the proposal in Section II below, 
and are further discussed in Section IV.
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II. Description of the Proposal

    CBOE Rule 6.74 sets forth the procedures by which a floor broker 
holding a customer order (``original order'') may cross it with either: 
(i) Another customer order or orders from the same originating firm: or 
(ii) a contra side order provided by the originating firm from its own 
proprietary account (``facilitation order'').\6\
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    \6\ Under the CBOE's rules, facilitation orders may be provided 
only to cross the orders of public customers. See CBOE Rule 6.74(b). 
This same stipulation is retained under the proposed rule change.
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    Under CBOE Rules 6.74(a) and (b), a floor broker seeking to cross 
buy and sell orders for the same options series must first bring the 
transaction to the trading floor and request a market from the trading 
crowd. After receiving bids and offers from the crowd, the floor broker 
must propose a price at which to cross the original order that improves 
upon the price provided by the crowd. However, before the floor broker 
can effect the cross, the market makers in the crowd are given the 
opportunity to take all or part of the transaction at the proposed 
price.\7\
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    \7\ In the case where the floor broker is proposing to cross two 
customer orders, the crowd may take all or part of either customer 
order. In the case where the floor broker is seeking to effect a 
facilitation cross, the crowd may take all or part of the customer 
order.
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    Under these rules, if the crowd does not want to participate in the 
trade, the floor broker may proceed with the cross. If the crowd wants 
to take part of the order, however, the crowd has precedence and the 
floor broker may cross only that amount remaining after

[[Page 35684]]

the crowd has taken its portion. If the crowd wants to take the entire 
order, the floor broker will not be able to cross or facilitate any 
part of the order.
    The proposed rule change, adding new paragraph (d) of Rule 6.74, 
will apply to transactions in equity options,\8\ and will pertain to 
orders of a certain minimum size. The qualifying size of orders 
eligible for the proposal's new rule will be determined by the 
appropriate Floor Procedure Committee of the Exchange, but cannot be 
less than 50 contracts.\9\ The proposed rule change will entitle the 
floor broker, under certain conditions, to cross a specified percentage 
of the original order on behalf of the originating firm, before market 
makers in the crowd can participate in the transaction. The percentage 
of the floor broker's guarantee will depend upon whether the price at 
which the order is ultimately traded is at the crowd's best bid or 
offer in response to the broker's initial request or at an improved 
price.
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    \8\ The CBOE has also filed a related rule change regarding 
facilitation crosses in index options. See Securities Exchange Act 
Release No. 41743 (August 13, 1999), 64 FR 45578 (August 20, 
1999)(File No. SR-DBOE-99-35).
    \9\ See Amendment No. 2 to the proposed rule change, concerning 
proposed paragraph 1 of Rule 6.74(d). The original proposal would 
have restricted the eligible order size to 500 contracts or more.
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    First, in contrast to the provisions of current rule 6.74, the 
floor broker will be granted a right to cross even at a price that does 
not improve upon the best bid or offer provided by the crowd in 
response to his initial request for a market. The proposed rule change 
provides that where the trade takes place at the market provided by the 
crowd, all public customer orders in the book and those represented in 
the trading crowd at the time the market was established \10\ must 
first be satisfied. Once these public customer orders are satisfied, 
the floor broker will be entitled to cross 20% of the contracts 
remaining in the original order.
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    \10\ See Amendment No. 3, concerning subsection 6.74(d)(ii).
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    The proposed rule change further provides that if the original 
order is traded at a price between the best bid and offer provided by 
the crowd in response to the floor broker's initial request for a 
market--i.e., where the floor broker proposes the cross at a price that 
improves the crowd's market, and the crowd then wants to take part or 
all of the order at the improved price--the floor broker will be 
entitled to priority over the crowd to cross 40% of the contracts.
    As under existing procedures codified in paragraphs (a) and (b) of 
Rule 6.74, the floor broker seeking to execute a cross under proposed 
paragraph (d) will be required, when initially asking for a market in 
the option series, to make all persons in the trading crowd, including 
the Order Book Official, aware of his request.
    Proposed paragraph (d)(i) provides, in addition, that once the 
trading crowd has provided a market, that market will remain in effect 
until (a) a reasonable amount of time has passed; (b) a significant 
change has occurred in the price of the underlying security of the 
option; or (c) the market is improved.\11\ In case of a dispute, 
``significant change'' will be determined on a case-by-case basis by 
two Floor Officials, based upon the extent of recent trading in the 
option and the underlying security and any other relevant factor.
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    \11\ See Amendment No. 2, concerning proposed subsection 
6.74(d)(i).
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    In the case of a multi-part or spread order, one leg alone of the 
order will need to meet the eligible size requirement to qualify for 
the provisions of the proposed rule change.
    In the case of a facilitation cross, the facilitating firm will be 
required to disclose on the order ticket for the public customer order 
all terms of the order, including any contingency involving, and all 
related transactions in, either options or underlying or related 
securities. The floor broker will be required to disclose all 
securities that are components of the public customer order before 
requesting bids and offers for the execution of all components of the 
order.\12\
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    \12\ See Amendment No. 2, concerning proposed subsection 
6.74(d)(iv).
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    If the same member organization of the Exchange is both the 
originating firm and the Designated Primary Market Maker (``DPM'') for 
the class of options in which the transaction takes place,\13\ and the 
floor broker acting on behalf of the firm takes advantage of the 
crossing right provided by the proposed rule change, the firm will not 
be entitled to any participated in the trade on the guaranteed 
percentage ordinarily granted to DPMs pursuant to CBOE Rule 8.80 (``DPM 
participation rate'').\14\ In this instance the firm will be limited to 
its guaranteed participation under Rule 6.74.
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    \13\ The same provision would apply if the originating firm or 
the DPM or both are nominees of the same member organization. 
Telephone conversation between Timothy Thompson, Assistant General 
Counsel, Legal Department, CBOE, and Gordon Fuller, Special Counsel, 
and Ira Brandriss, Attorney, Division of Market Regulation 
(``Division''), the Commission, on May 22, 2000.
    \14\ See CBOE Rule 8.80(c)(7); Securities Exchange Act Release 
No. 42190 (December 1, 1999), 64 FR 68706 (December 8, 1999) 
(establishing the DPM guarantee at 30% when the trade occurs at the 
DPM's principal bid or offer).
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    If the DPM in the options class is not the same member organization 
as the originating firm, and the trade takes place at the DPM's 
principal bid or offer, the DPM will be entitled to participate in a 
percentage of the contracts remaining after relevant public customer 
orders have been filled and the originating firm's crossing rights have 
been exercised. The percentage that the DPM will receive is determined 
by reference to the established DPM participation rate--subject to 
limitation. If the floor broker crosses the full 20% of the originating 
firm's entitlement, the number of contracts guaranteed to the DPM may 
not exceed 25% of the remaindere of the order after the originating 
firm has taken its share.\15\ If the floor broker does not cross 20%, 
the DPM may be entitled to more, but in no case will the DPM be 
guaranteed a percentage that, when combined with the percentage crossed 
by the floor broker, exceeds 40% of the original order (after relevant 
public customer orders have been satisfied).\16\
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    \15\ Thus, if the original order was for 1,000 contracts, and 
the originating firm, crossing at the best bid or offer price given 
by the crowd, took its full share of 200 contacts (20%)--assuming no 
public customer orders were represented in the book or in the 
crowd--the DPM would be entitled to 200 contracts (25% of the 
remaining 800) and the total combined participation guarantees of 
the originating firm and the DPM would be limited to 400 contracts, 
or 40% of the original order.
    \16\ See Amendment No. 2, concerning proposed subsection 
6.74(d)(v).
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    The proposed rule change makes clear, however, that it is not 
intended to prohibit either a floor broker or DPM from trading more 
than their percentage entitlements if the other members of the trading 
crowd do not choose to trade with the remainder of the order.\17\
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    \17\ Id., concerning proposed subsection 6.74(d)(vii).
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    The proposal further makes clear, in accordance with Rule 8.80, 
that if the trade takes place at a price other than that of the DPM's 
principal bid or offer, the DPM would not be entitled to any guaranteed 
participation.\18\
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    \18\ Id., concerning proposed subsection 6.74(d)(v). Thus, the 
DPM participation right is not a concern where the originating firm 
receives a 40% crossing right, because that right is granted only 
when the trade occurs between the best bid and offer given by the 
crowd, which is by definition at a price other than the DPM's 
principal bid or offer.
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    The proposed rule change also provides that the members of the 
crowd who establish the market in response to the floor broker's 
initial request will have priority over all other orders that were not 
represented in the crowd at the time that market was established, 
except for orders that improve upon those

[[Page 35685]]

quotes. Further, a floor broker holding a customer order and either a 
facilitation order or a solicited order and who makes a request for a 
market will be deemed to be representing both the customer order and 
either the facilitation order or solicited order, so that the customer 
order and the other order will also have priority over all other orders 
that were not being represented in the trading crowd at the time the 
market was established.\19\
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    \19\ See Amendment Nos. 2 and 3, concerning proposed subsection 
6.74(d)(vi).
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III. Summary of Comments

    The Commission received four comment letters regarding the proposed 
rule change. One commenter, the Amex Options Market Maker Association 
(``OMMA''),\20\ opposed the proposal. Three commenters--Morgan Stanley 
& Co. (``Morgan Stanley''),\21\ Goldman, Sachs & Co. (``Goldman 
Sachs''),\22\ and Credit Suisse First Boston Corporation (``CSFB'') 
\23\--supported it.
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    \20\ Letter from Daniel Mintz, Chairman, Amex Option Market 
Makers Association, to the Securities and Exchange Commission, dated 
May 28, 1999 (resubmitted with technical clarification, August 19, 
1999).
    \21\ Letter from Robin Roger, Principal and Legal Counsel, 
Morgan Stanley & Co., to Jonathan G. Katz, Secretary, Commission, 
dated August 9, 1999.
    \22\ Letter from Mark A. Zurack, Managing Director, Goldman, 
Sachs & Co., to Jonathan G. Katz, Secretary, Commission, dated 
August 27, 1999.
    \23\ Letter from Raymond J. Dorado, Director and Counsel, Legal 
and Compliance Department, Credit Suisse First Boston Corporation, 
to Jonathan G. Katz, Secretary, Commission, dated September 30, 
1999.
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    The OMMA stated that the proposed rule change would harm investors 
because when floor brokers representing customer orders are guaranteed 
the right to cross a fixed percentage of those orders, they will no 
longer attempt to seek the best price possible for those orders. The 
OMMA further maintained that the auction market would be cut short 
under the proposed rule change, and that the participation guarantees 
granted to upstairs firms will remove the incentive for market makers 
to improve prices.
    CSFB and Morgan Stanley stated that the proposal would contribute 
to more efficient markets and the narrowing of spreads for listed 
options. The guaranteed participation, they maintained, would provide 
an incentive for originating firms to find contraparty customers or to 
commit their own capital at a price between the spread. They also argue 
that it would correct an inequity under current rules that allows 
market makers to take 100% of a proposed cross away from an originating 
firm.
    Goldman Sachs adds that, under the proposal, the crossing price 
would of necessity be fair to the customer, because the originating 
firm is guaranteed a participation right only for a cross at or better 
than the quoted market. Moreover, it noted, firms would have an 
incentive to bring liquidity to the market and market makers would have 
an incentive to quote tighter markets in order to increase their 
participation.
    The commenters who supported the proposal also maintained that it 
would enable the CBOE to compete effectively with other exchanges.
    The CBOE responded to OMMA's comments in Amendment No. 1 to the 
proposal. The CBOE stated that, contrary to suggestions made by the 
OMMA, market makers would always have an opportunity to improve the 
market under the proposed rule change, and a cross could never be 
executed outside the best quoted market.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the provisions of the Act applicable to a 
national securities exchange, particularly those of section 6(b)(5) 
\24\ and section 6(b)(8) \25\ of the Act, and the rules and regulations 
thereunder.\26\ The Commission believes that the proposal will enable 
the CBOE to better compete with other options exchanges in attracting 
the order flow of broker-dealer firms seeking to cross and facilitate 
customer orders, without adversely impacting the prices those orders 
receive.
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    \24\ 15 U.S.C. 78f(b)(5). Section 6(b)(5) requires that the 
rules of a national securities exchange be designed to, among other 
things, promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market, 
and, in general, to protect investors and the public interest. It 
also requires that those rules not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.
    \25\ 15 U.S.C. 78f(b)(8). Section 6(b)(8) requires that the 
rules of the exchange do not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act.
    \26\ In approving this proposal, 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 Commission finds that the CBOE's proposal to grant 
participation rights, under certain conditions, to member firms that 
execute crossing transactions on the Exchange is reasonable. Currently, 
CBOE market makers have priority rights for the full size of a customer 
order over the firm that brings a crossing transaction to the CBOE 
floor, as long as the market makers are willing to trade at the 
proposed price.
    While the proposal entitles the originating firm to a specified 
percentage of a crossing transaction when executed at the trading 
crowd's best bid or offer, it does not eliminate the crowd's ability to 
trade with a portion of the order proposed to be crossed, or even so 
substantially reduce that ability so as to raise serious concern that 
the proposal would reduce price competition by the crowd. Moreover, the 
Commission believes that the proposal may contribute to better prices 
for crossing transactions. Specifically, it provides an incentive for 
upstairs firms to improve on the prices quoted by the crowd by offering 
these firms a greater participation in the trade when they better the 
crowd's price. In addition, as the CBOE represents, market makers will 
always have an opportunity to improve the market and compete for a 
greater portion of the trade.
    In evaluating the proposed rule change, the Commission considered, 
among other matters, whether the CBOE's proposal to guarantee that an 
originating firm could cross up to 40% of an order would reduce the 
incentive of crowds to compete for orders, and thus impair the price 
discovery mechanism of the Exchange's market.
    In its recent approval of the application of the International 
Securities Exchange (``ISE'') for registration as a national securities 
exchange, the Commission discussed the same concern with respect to the 
ISE's proposed ``facilitation mechanism,'' a system designed to effect 
a type of facilitation guarantee in an electronic context. The 
Commission wrote:

    It is difficult to assess the precise level at which guarantees 
may begin to erode competitive market maker participation and 
potential price competition within a given market. In the future, 
after the Commission has studied the impact of guarantees, the 
Commission may need to reassess the level of these guarantees. For 
the immediate term, the Commission believes that 40% is not clearly 
inconsistent with the statutory standards of competition and free 
and open markets.\27\
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    \27\ See Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000).

    By the same token, the Commission believes that the CBOE's proposed 
rule change, which allocates no more than 40% of an order to the firm 
seeking to effect a cross, is not inconsistent with the statutory 
standard. The Commission notes, moreover, that for those crossing 
transactions in which a DPM is entitled to an allocation in addition to 
the proposed allocation for the originating firm, the CBOE has included 
a provision

[[Page 35686]]

to limit the combined allocations awarded to the originating firm and 
the DPM an aggregate of no more than 40% of the order.
    The Commission finds good cause for approving Amendment Nos. 1, 2, 
and 3 to the proposal prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1 provides additional representations concerning the 
operation of the proposal and its rationale, and responds to concerns 
raised by the OMMA. Amendment No. 1 made only a minor change in the 
text of the proposed rule change for purposes of clarification.\28\
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    \28\ The change was intended to clarify when the provisions of 
subparagraphs (a) and (b) of CBOE Rule 6.74 apply, and when new 
paragraph (d) applies. The language was subsequently modified 
further to the same end by Amendment No. 2.
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    Amendment No. 2, among other things, modifies the proposed rule 
change by reducing the minimum size of orders to which it will be 
applicable, from 500 to 50 contracts. The Commission has already 
approved the facilitation mechanism of the ISE, which guarantees 40% of 
orders to facilitating firms for order sizes of 50 or more 
contracts.\29\ Thus, the reduction in the size requirement in the CBOE 
proposal raises no new regulatory issues. Further, it will benefit 
options market participants by allowing for substantially consistent 
treatment of crossing mechanisms under the rules of the ISE and the 
CBOE, and will allow the CBOE to compete without disadvantage for 
facilitation orders.\30\
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    \29\ See Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000).
    \30\ Although the ISE mechanism operates only for facilitation 
crosses, the Commission's grounds for approving the ISE's 
facilitation cross guarantee apply equally to the CBOE's proposal, 
which applies to both customer-to-customer and facilitation crosses.
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    Amendment No. 2 further adds the stipulation that the combined 
guarantees of the firm and the DPM may not exceed 40% of the order, 
thus limiting allocations to a percentage that the Commission has 
previously found consistent with the Act.
    Amendment No. 2 also clarifies the period that the market 
established by the crowd in response to the floor broker's initial 
request will remain in effect.\31\ It further established the priority 
of crowd members who responded to the initial request for a quotation 
over orders that were not represented in the crowd at the time the 
market was established (unless those orders improve the price), as well 
as the priority of any unfilled portion of the crossing order held by 
the floor broker. These aspects of the amendment constitute appropriate 
and necessary clarifications of procedures and priority rights under 
the proposed rule change.
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    \31\ See text accompanying note 9, supra.
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    Amendment No. 2 further adds disclosure requirements for 
facilitation crosses transacted under the proposed rule change, 
consistent with disclosure requirements for facilitation crosses 
transacted under current rules. These provisions strengthen the 
proposed rule change and raise no new regulatory issues.
    Amendment Nos. 2 and 3 set forth explicitly that the crossing 
guarantee applies only after all public customer orders on the limit 
order book and those represented in the trading crowd at the time the 
market was established have been satisfied. This aspect of the 
amendment thus limits the new entitlement granted to floor brokers 
under the proposed rule change, preserving priority for public customer 
orders.
    Amendment No. 3 additionally adds language to the proposed rule 
text to clarify that public customer orders on the limit order book 
will always have priority over members of the trading crowd who 
established the market; that those members of the crowd will have 
priority over non-customer orders as well as public customer orders on 
the floor that were not represented at the time the market was 
established; and that the crowd will not have priority over any order--
customer or non-customer--that improves the market. These changes were 
made for the purposes of clarity and consistency and thus strengthen 
the proposed rule change.
    Amendment No. 3 also provides that the Floor Procedure Committee 
will determine the size requirement for orders to be subject to the 
crossing guarantee on a class by class basis. In the Commission's view, 
this provision will afford the Exchange greater flexibility in 
determining when it is appropriate to provide participation rights to 
firms seeking to cross orders, and thus strengthens the proposed rule 
change.
    Accordingly, the Commission finds good cause, consistent with 
Sections 6(b)(5) \32\ and 19(b)(2) \33\ of the Act to accelerate 
approval of Amendments No. 1, 2, and 3 to the proposed rule change.
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    \32\ 15 U.S.C. 78f(b)(5).
    \33\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 1, 2, and 3, including whether 
Amendment Nos. 1, 2, and 3 are 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 CBOE. All submissions should refer to File No. 
SR-CBOE-99-10 and should be submitted by June 26, 2000.

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to section 19(b)(2) of the Act, 
that the proposed rule change (SR-CBOE-99-10), as amended, be and 
hereby is approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\34\
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    \34\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-13955 Filed 6-2-00; 8:45 am]
BILLING CODE 8010-01-M