[Federal Register Volume 88, Number 185 (Tuesday, September 26, 2023)]
[Notices]
[Pages 66111-66114]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-20808]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-98450; File No. SR-ISE-2023-08]


Self-Regulatory Organizations; Nasdaq ISE, LLC; Order Granting 
Approval of a Proposed Rule Change, as Modified by Amendment No. 1, To 
Make Permanent Certain P.M.-Settled Pilots

September 20, 2023.

I. Introduction

    On February 23, 2023, Nasdaq ISE LLC (``ISE'' 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 
make permanent the pilot program to permit the listing and trading of 
options based on \1/5\ the value of the Nasdaq-100 Index (``Nasdaq-
100'') and the Exchange's nonstandard expirations pilot program 
(collectively, the ``Programs''). The proposed rule change was 
published for comment in the Federal Register on March 2, 2023.\3\ On 
April 7, 2023, pursuant to section 19(b)(2) of the Act,\4\ the 
Commission designated a longer period within which to approve the 
proposed rule change, disapprove the proposed rule change, or institute 
proceedings to determine whether to disapprove the proposed rule 
change.\5\ On May 11, 2023, the Exchange filed Amendment No. 1 to the 
proposed rule change (``Amendment No. 1'').\6\ On May 31, 2023, the 
Commission instituted proceedings to determine whether to approve or 
disapprove the proposed rule change and published Amendment No. 1 for 
notice and comment.\7\ On August 28, 2023, the Commission designated a 
longer period for Commission action on proceedings to determine whether 
to approve or disapprove the proposed rule change, as modified by 
Amendment No. 1.\8\ The Commission did not receive any comment letters 
and is approving the proposed rule change, as modified by Amendment No. 
1.
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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. 96979 (February 24, 
2023), 88 FR 13182 (``Notice'').
    \4\ 15 U.S.C. 78s(b)(2).
    \5\ See Securities Exchange Act Release No. 97261, 88 FR 22509 
(April 13, 2023). The Commission designated May 31, 2023, as the 
date by which the Commission shall approve or disapprove, or 
institute proceedings to determine whether to approve or disapprove, 
the proposed rule change.
    \6\ In Amendment No. 1, the Exchange inserts two footnotes and 
amends a sentence in order to further clarify parts of the empirical 
analysis performed by the Exchange. Amendment No. 1 is available at: 
https://www.sec.gov/comments/sr-ise-2023-08/srise202308.htm.
    \7\ See Securities Exchange Act Release No. 97626, 88 FR 37110 
(June 6, 2023).
    \8\ See Securities Exchange Act Release No. 98233, 88 FR 60516 
(September 1, 2023). The Commission designated October 28, 2023, as 
the date by which the Commission shall either approve or disapprove 
the proposed rule change.
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II. Background

    When cash-settled \9\ index options were first introduced in the 
1980s, they generally utilized closing-price settlement procedures 
(i.e., p.m. settlement).\10\ The Commission became concerned with the 
impact of p.m.-settled, cash-settled index options on the underlying 
cash equities markets, and in particular, added market volatility and 
sharp price movements near the close on expiration days.\11\ These 
concerns were heightened during the ``triple-witching'' hour on the 
third Friday of March, June, September, and December when index 
options, index futures, and options on index futures expired 
concurrently.\12\ Academic research at the time provided at least some 
evidence suggesting that futures and options expirations contributed to 
excess volatility and reversals around the close on those days.\13\
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    \9\ The seller of a ``cash-settled'' index option pays out the 
cash value of the applicable index on expiration or exercise. A 
``physical delivery'' option, like equity and ETF options, involves 
the transfer of the underlying asset rather than cash. See 
Characteristics and Risks of Standardized Options, available at: 
https://www.theocc.com/Company-Information/Documents-and-Archives/Options-Disclosure-Document.
    \10\ See Securities Exchange Act Release No. 65256 (September 2, 
2011), 76 FR 55969, at 55972 (September 9, 2011) (SR-C2-2011-008) 
(Order approving proposed rule change to establish a pilot program 
to list and trade SPXPM options on the C2 Options Exchange, 
Incorporated) (``C2 SPXPM Approval'').
    \11\ See id.
    \12\ See id.
    \13\ See Securities and Exchange Commission, Division of 
Economic Risk and Analysis, Memorandum dated February 2, 2021 on 
Cornerstone Analysis of PM Cash-Settled Index Option Pilots 
(September 16, 2020) (``Pilot Memo'') at 5, available at: https://www.sec.gov/files/Analysis_of_PM_Cash_Settled_Index_Option_Pilots.pdf (citing, among 
other papers, Stoll, Hans R., and Robert E. Whaley, ``Expiration day 
effects of index options and futures,'' Monograph Series in Finance 
and Economics, no. 3 (1986)).
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    In light of the concerns with p.m. settlement and to help 
ameliorate the price effects associated with expirations

[[Page 66112]]

of p.m.-settled, cash-settled index products, in 1987, the Commodity 
Futures Trading Commission approved a proposed rule change by the 
Chicago Mercantile Exchange (``CME'') to provide for a.m. settlement 
\14\ for index futures, including futures on the S&P 500 Index.\15\ The 
Commission subsequently approved a proposed rule change by Cboe Options 
Exchange (``Cboe Options'') to list and trade a.m.-settled options on 
the S&P 500 Index.\16\ In 1992, the Commission approved Cboe Options' 
proposal to transition all of its European-style cash-settled options 
on the S&P 500 Index to a.m. settlement.\17\ However, in 1993, the 
Commission approved a proposed rule change allowing Cboe Options to 
list p.m.-settled options on certain broad-based indexes, including the 
S&P 500, expiring at the end of each calendar quarter (since approved 
as permanent).\18\ Starting in 2006, the Commission approved a number 
of proposals, on a pilot basis, permitting Cboe Options to introduce 
other index options with p.m.-settlement. These include p.m.-settled 
index options expiring weekly (other than the third Friday) and at the 
end of each month,\19\ as well as p.m.-settled S&P 500 Index options 
and Mini-S&P 500 Index options expiring on the third Friday of the 
month.\20\
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    \14\ The exercise settlement value for an a.m.-settled index 
option is determined by reference to the reported level of the index 
as derived from the opening prices of the component securities on 
the business day before expiration.
    \15\ See Proposed Amendments Relating to the Standard and Poor's 
500, the Standard and Poor's 100 and the Standard Poor's OTC Stock 
Price Index Futures Contract, 51 FR 47053 (December 30, 1986) 
(notice of proposed rule change from the CME). See also Securities 
Exchange Act Release No. 24367 (April 17, 1987), 52 FR 13890 (April 
27, 1987) (SR-CBOE-87-11) (noting that the CME moved the S&P 500 
futures contract's settlement value to opening prices on the 
delivery date).
    \16\ See Securities Exchange Act Release No. 24367 (April 17, 
1987), 52 FR 13890 (April 27, 1987) (SR-CBOE-87-11).
    \17\ See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992) (SR-CBOE-92-09). The Commission 
also approved proposals by other options markets to transfer most of 
their cash-settled index products to a.m. settlement. See, e.g., 
Securities Exchange Act Release No. 25804 (June 15, 1988), 53 FR 
23475 (June 22, 1988) (SR-NYSE-87-11 and 88-04).
    \18\ See Securities Exchange Act Release No. 31800 (February 1, 
1993), 58 FR 7274 (February 5, 1993) (SR-CBOE-92-13). See also 
Securities Exchange Act Release Nos. 54123 (July 11, 2006), 71 FR 
40558 (July 17, 2006) (SR-CBOE-2006-65); and 60164 (June 23, 2009), 
74 FR 31333 (June 30, 2009) (SR-CBOE-2009-029).
    \19\ See Securities Exchange Act Release Nos. 62911 (September 
14, 2010), 75 FR 57539 (September 21, 2010) (SR-CBOE-2009-075); 
76529 (November 30, 2015), 80 FR 75695 (December 3, 2015) (SR-CBOE-
2015-106); and 78531 (August 10, 2016), 81 FR 54643 (August 16, 
2016) (SR-CBOE-2016-046).
    \20\ See Securities Exchange Act Release Nos. 68888 (February 8, 
2013), 78 FR 10668 (February 14, 2013) (SR-CBOE-2012-120); and 70087 
(July 31, 2013), 78 FR 47809 (August 6, 2013) (SR-CBOE-2013-055).
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    Subsequently, other exchanges, including ISE, sought to permit the 
listing and trading of p.m.-settled options on certain broad-based 
indices. In February 2018, the Commission approved ISE's nonstandard 
expirations pilot program on a pilot basis (``Nonstandard Pilot'').\21\ 
In March 2018, the Commission approved ISE's pilot to permit the 
listing and trading of options based on the Nasdaq 100 Reduced Value 
Index (``NQX'' or ``NQX options'') on a pilot basis (``NQX 
Pilot'').\22\ In the course of approving both Programs, the Commission 
reiterated its concern about the potential impact on the market at 
expiration for the underlying component stocks for a p.m.-settled, 
cash-settled index option.\23\ However, the Commission also recognized 
the potential impact was unclear.\24\ The Commission approved the 
Programs on a pilot basis to allow the Exchange and the Commission to 
monitor for and assess any potential for adverse market effects.\25\ In 
order to facilitate this assessment, the Exchange committed to provide 
the Commission with data and analysis for each pilot \26\ and to make 
such data publicly available.\27\ In addition to the Exchange's data 
and analysis, Cornerstone Research also conducted an analysis at the 
direction of Staff from the Commission's Division of Economic and Risk 
Analysis. The analysis utilizes the level of expiring p.m.-settled 
index options open interest and the measures of volatility and price 
reversals for the corresponding index futures, the underlying cash 
index, and index component securities in the minutes leading up to and 
immediately following the market close to study the effects of pilot 
programs allowing p.m.-settled index options. The Pilot Memo is 
discussed in more detail below.
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    \21\ See Securities Exchange Act Release No. 92612 (February 1, 
2018), 83 FR 5470 (February 7, 2018) (SR-ISE-2017-111) 
(``Nonstandard Approval Order''). The Commission subsequently 
approved a proposed rule change to amend the Program to allow the 
Exchange to also list p.m.-settled Tuesday and Thursday expirations 
on the Nasdaq-100. See Securities Exchange Act Release No. 95393 
(July 29, 2022), 87 FR 47807 (August 4, 2022) (SR-ISE-2022-13).
    \22\ See Securities Exchange Act Release No. 82911 (March 20, 
2018), 83 FR 12966 (March 26, 2018) (SR-ISE-2017-106) (``NQX 
Approval Order'').
    \23\ See Nonstandard Approval Order, 83 FR at 5472 and NQX 
Approval Order 83 FR at 12967. See also Securities Exchange Act 
Release Nos. 64599 (June 3, 2011), 76 FR 33798, 33801-02 (June 9, 
2011) (order instituting proceedings to determine whether to approve 
or disapprove a proposed rule change to allow the listing and 
trading of SPXPM options); C2 SPXPM Approval, 76 FR at 55972-76; and 
68888 (February 8, 2013), 78 FR 10668, 10669 (February 14, 2013) 
(order approving the listing and trading of SPXPM on Cboe Options).
    \24\ See NQX Approval Order, 83 FR at 12967.
    \25\ See NQX Approval Order, 83 FR at 12967 and Nonstandard 
Approval Order, 83 FR at 5473.
    \26\ See NQX Approval Order, 83 FR at 12966-12967 and 
Nonstandard Approval Order, 83 FR at 5471-5472.
    \27\ See, e.g., Securities Exchange Act Release Nos. 85672 
(April 17, 2019), 84 FR 16899, at 16899 (April 23, 2019) (SR-ISE-
2019-11) (stating the Exchange will make public on its website any 
data and analysis it submits to the Commission under the Nonstandard 
Pilot); and 86071 (June 10, 2019) 84 FR 27822, at 27823 (June 14, 
2019) (SR-ISE-2019-18) (stating the Exchange is making public on its 
website data and analysis previously submitted to the Commission 
under the NQX Pilot and committing to make public any data or 
analyses submitted in the future).
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III. Description of the Proposal, as Modified by Amendment No. 1

    The Exchange proposes to make permanent the Nonstandard Pilot and 
the NQX pilot. The Nonstandard Pilot permits the Exchange to open p.m.-
settled options on broad-based indexes that expire (1) on the last day 
of the trading month (``EOM expirations'') and (2) on any Monday, 
Wednesday, or Friday (other than the third Friday-of-the-month or days 
that coincide with an EOM expiration) and, with respect to options on 
the Nasdaq-100 (``NDX'' or ``NDX options''), any Tuesday or Thursday 
(other than days that coincide with the third Friday-of-the-month or an 
EOM expiration). The NQX Pilot permits the listing of NQX options, 
which are European-style and cash-settled, and have a contract 
multiplier of 100. The contract specifications for NQX options mirror 
those of the NDX options contract listed on the Exchange, except that 
NQX options are based on \1/5\ of the value of the Nasdaq-100, and are 
p.m.-settled pursuant to Options 4A, section 12(a)(6) of the ISE Rules.
    The Nonstandard Pilot was extended on multiple occasions, including 
recently, and is set to expire on November 6, 2023.\28\ Similarly, the 
NQX Pilot was extended on multiple occasions and is set to expire on 
November 6, 2023.\29\
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    \28\ See Securities Exchange Act Release No. 97386 (April 26, 
2023), 88 FR 27545, at 27546-27547 (May 2, 2023) (SR-ISE-2023-09) 
(``Programs Extension'').
    \29\ See id.
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    The Exchange states it has provided pilot data to the Commission 
with respect to the Programs, pursuant to the Nonstandard Approval 
Order and the NQX Approval order.\30\ The Exchange

[[Page 66113]]

also states it provides ongoing monthly data in addition to the data 
provided in the Notice.\31\ Now, the Exchange proposes to make the 
Programs permanent.
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    \30\ See Notice, 88 FR at 13197. The Exchange has made public on 
its website data and analyses previously submitted to the Commission 
under the Programs. See http://www.nasdaqtrader.com/Trader.aspx?id=currentregulatory.
    \31\ See Programs Extension, 88 FR at 27546-27547.
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IV. Discussion and Commission Findings

    After careful review, 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.\32\ In particular, the Commission finds that the 
proposed rule change, as modified by Amendment No. 1, is consistent 
with section 6(b)(5) of the Act,\33\ which requires, among other 
things, that the Exchange's rules be designed to prevent fraudulent and 
manipulative acts and practices, 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. In its proposal 
to make the Programs permanent, the Exchange addressed market capacity 
around the market close and provided an empirical assessment of the 
impact of its p.m.-settled index options on options market quality. 
Each of these elements is discussed in greater detail below. As stated 
above, no comments were received on the proposed rule change.
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    \32\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \33\ 15 U.S.C. 78f(b)(5).
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Market Impact Considerations

    The Exchange's analysis presents data that the introduction of 
p.m.-settlement is correlated with an increase in options trading tied 
to the Nasdaq-100.\34\ The data shows an increase in trading volume and 
notional open interest for NDX and NQX options during the sample 
period.\35\
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    \34\ See Notice, 88 FR at 13184.
    \35\ See id.
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    In addition to reviewing the data and analysis provided by the 
Exchange, the Commission reviewed the analysis in the Pilot Memo, which 
evaluates whether higher levels of expiring open interest in p.m.-
settled index options results in increased volatility and price 
reversals around the close. The Pilot Memo shows that the market share 
for p.m.-settled options, in particular options on S&P 500 Index, has 
grown substantially since 2007.\36\ The Pilot Memo examines whether and 
to what extent expiring open interest in p.m.-settled index options is 
empirically related with the tendency of the corresponding index 
futures, the underlying index, or index components to experience 
increased transitory volatility and price reversals around the time of 
market close on expiration dates. The Pilot Memo concludes that, 
although expiring p.m.-settled index option open interest may have a 
statistically significant relationship with volatility and price 
reversals of the underlying index, index futures, and index component 
securities around the market close, the magnitude of the effect is 
economically very small.\37\ For example, the largest settlement event 
that occurred during the time period studied in the Pilot Memo (a 
settlement of $100.4 billion of notional on December 29, 2017) had an 
estimated impact on the futures price of only approximately 0.02% (a 
predicted impact of $0.54 relative to a closing futures price of 
$2,677).\38\
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    \36\ See Pilot Memo at 2. The Pilot Memo also examined options 
on the Russell 2000 Index and the Nasdaq-100. However, during the 
time period covered by the study (2007-2018), the markets for both 
a.m.- and p.m.-settled options on these indexes were very small 
compared to the size of that for S&P 500 Index options. In addition, 
because p.m.-settled NDX options were only introduced in 2018, the 
number of observations for NDX options was much smaller than for 
other indexes. See id. at 4.
    \37\ See id. at 3.
    \38\ See id.
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    In order to analyze the effect of a very large increase in 
settlement volume for Nasdaq-100 p.m.-settled options contracts, the 
Exchange uses the estimated regression coefficients in the Pilot Memo 
to estimate the change in the volatility of index futures prices when 
settlement volume increased from the 25th percentile to the 75th 
percentile.\39\ For both the S&P 500 Index and the Nasdaq-100, the 
Exchange estimates the relative impact would be small for both 
indexes.\40\
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    \39\ See Notice, 88 FR at 13195.
    \40\ See id.
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    The Exchange also provides additional analysis on market capacity 
around the market close.\41\ Specifically, the Exchange presents data 
that the closing auction volume on the equity market have become much 
larger than the opening auction, which may indicate that there is 
sufficient liquidity in closing auctions to absorb liquidity demand 
associated with p.m.-settlement of NDX and NQX options.\42\ In 
addition, the Exchange states that the liquidity available at or around 
the close would be able to mitigate any excess volatility created by 
the options settlement at the market close.\43\
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    \41\ See id. at 13195-13196.
    \42\ See id. at 13196.
    \43\ See id.
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    Further, the Exchange represents that it has sufficient systems 
capacity to handle p.m.-settled options on broad-based indexes with 
nonstandard expirations dates and has not encountered any issues or 
adverse market effects as a result of listing them.\44\
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    \44\ See Notice, 88 FR at 13197.
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Market Quality Considerations

    The Exchange also completed an analysis intended to evaluate 
whether the Programs impacted the quality of the NDX options market. 
Specifically, the Exchange presents findings on three market 
characteristics: trading volume, open interest, and spreads. The 
Exchange concludes that there is no evidence that NDX and NQX options 
contracts, which are p.m.-settled, would result in reduced trading 
activity or degradation in market quality of the a.m.-settled index 
options.\45\ The Exchange notes within its analysis that it seems 
unlikely that the introduction of NQX option contracts had a 
significant impact on the market quality of the full-sized NDX option 
contracts.\46\
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    \45\ See id. at 13184.
    \46\ The Exchange states that given that the size of the market 
(measured in volume) for NQX options volume is small compared to 
that of other p.m.-settled NDX options, the Exchange believes the 
introduction of NQX option contracts is unlikely to adversely impact 
the market quality of a.m.-settled NDX options. See Amendment No. 1, 
supra note 6.
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    Further, the Exchange observed a consistent decrease in relative 
quoted spread from 2017 to 2022 for NDX options.\47\ When the Exchange 
compared the spread trend of NDX monthly contracts to that of QQQ 
monthly contracts, the Exchange states that the results suggest that 
there is gradual decrease in both the NDX monthly contracts spread and 
the QQQ contracts spread during the sample period.\48\ The Exchange 
uses duration weighted relative quoted spread as a measure of the cost 
of trading and examines whether the introduction of p.m.-settled index 
options results in any deterioration of spreads for am-settled NDX 
options.\49\ The Exchange finds a consistent decrease in the relative 
quoted spread is prevalent from 2017 to 2022 and no obvious change in 
the trend following the introduction of p.m.-settled index options.\50\ 
The analysis also considered whether the move from a.m. settlement to 
p.m. settlement for Friday weekly expirations

[[Page 66114]]

(other than third-Friday-of-the-month) led to changes in spreads for 
those contracts.\51\ The sample timeframe was from July 2017 through 
August 2018.\52\ The relative quoted spread decreased during first part 
of 2018 and increase in May and June 2018; however, it remained 
comparable to the 2017 average.\53\ Overall, the Exchange observes no 
evidence of deterioration of spreads associated with the introduction 
of p.m.-settled NDX options.\54\
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    \47\ See Notice, 88 FR at 13191.
    \48\ See id. at 13192, 13197.
    \49\ See id. at 13190-13191.
    \50\ See id.
    \51\ See id. at 13194.
    \52\ See id. The Exchange used a regression analysis to test 
whether the spread of NDX contracts changed after the introduction 
of p.m.-settled index options. See id. The regression model is meant 
to study the effect of the introduction of Friday p.m.-settled NDX 
options expirations (on all but the third Friday of the month) that 
occurred in January 2018. See Amendment No. 1, supra note 6.
    \53\ See Notice, 88 FR at 13194.
    \54\ See id.
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    The Commission believes that the evidence contained in the 
Exchange's filing, the Exchange's pilot data and reports, and the Pilot 
Memo analysis demonstrate that the Programs have benefitted investors 
and other market participants by providing more flexible trading and 
hedging opportunities while also having no disruptive impact on the 
market. The market for p.m.-settled options has grown in size over the 
course of the Programs, and analysis of the pilot data did not identify 
any significant economic impact on the underlying component securities 
surrounding the close as a result of expiring p.m.-settled options nor 
did it indicate a deterioration in market quality (as measured by 
relative quoted spreads) for an existing product when a new p.m.-
settled expiration was introduced. Further, significant changes in 
closing procedures in the decades since index options moved to a.m. 
settlement may also serve to mitigate the potential impact of p.m.-
settled index options on the underlying cash markets.
    Accordingly, the Commission finds that the proposed rule change, as 
modified by Amendment No. 1, is consistent with section 6(b)(5) of the 
Act \55\ and the rules and regulations thereunder applicable to a 
national securities exchange.
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    \55\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\56\ that the proposed rule change (SR-ISE-2023-08), as modified by 
Amendment No. 1, be, and hereby is, approved.
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    \56\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\57\
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    \57\ 17 CFR 200.30-3(a)(12).
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Sherry R. Haywood,
Assistant Secretary.
[FR Doc. 2023-20808 Filed 9-25-23; 8:45 am]
BILLING CODE 8011-01-P