[Federal Register Volume 62, Number 207 (Monday, October 27, 1997)]
[Notices]
[Pages 55663-55665]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28307]


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

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39261; File No. SR-CBOE-97-50]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Chicago Board Options Exchange, Inc. to Relating to ``Go 
Along'' Orders

October 20, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on 
September 25, 1997, the Chicago Board Options Exchange, Inc. (``CBOE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the self-regulatory 
organization. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The CBOE proposes to issues a regulatory circular which would 
establish the representation of ``go along'' orders on the floor of the 
Exchange as a violation of just and equitable principles of trade 
pursuant to Exchange Rule 4.1. The text of the proposed rule change is 
available at the Office of the Secretary, CBOE and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the self-regulatory organization 
included statements concerning the purpose of and basis for the 
proposed rule change and discussed any comments it received on the 
proposed rule change. The text of these statements may be examined at 
the places specified in Item IV below. The self-regulatory organization 
has prepared summaries, set forth in Sections A, B, and C below, of the 
most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purposes of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The purpose of the proposed rule change is to prohibit floor 
brokers from representing or executing ``go along'' orders (as further 
described below) on the floor of the Exchange. The representation or 
execution of such orders will be considered an act inconsistent with 
just and equitable principles of trade pursuant to Exchange Rule 4.1. 
The Exchange proposes to set forth the prohibition against the 
representation of ``go along'' orders in a regulatory circular 
describing the types of conduct which would be considered to be 
violative of just and equitable principles of trade.
    Definition of ``Go Along'' Orders: Generally, a ``go along'' order, 
or a ``not held with the crowd'' order, is an order that instructs a 
floor broker to bid or offer (as appropriate for the type of order) at 
the price established by the other participants in the trading crowd. 
Generally, the customer will specify whether the order is to buy or 
sell, the number of contracts, the series, and the strike price. 
Typically, the floor broker will be instructed to buy when the majority 
of the of the market-makers participating on a trade are selling. These 
orders often are placed by market-making firms as a side business, by 
upstairs broker-dealers who want to participate in ``market making,'' 
and by specialists on other exchanges. These orders are entered in both 
multiply-traded and singly listed option classes. As proposed, such an 
order would be prohibited even if the bid or offer does not match 
exactly the price established by the other participants in the trading 
crowd as long as the customer has given the broker discretion to 
determine what to bid or offer based upon the prices established by the 
other participants.
    Rationale for the Prohibition Against ``Go Along Orders'': The 
Exchange believes that the continued representation of this class of 
orders on the floor of the Exchange poses a serious threat to the 
continued viability of the CBOE market-maker system, as explained 
below.
    The execution of ``go along'' orders provides a disincentive to the 
transaction of a market-making business and thus, threatens the 
continued viability of the market-making system.
    The CBOE believes its market-marker system has, since its 
inception, provided liquid, deep, fair, and reliable markets for 
hundreds of option classes in thousands of different series. These 
liquid markets are brought about through the efforts of numerous 
market-makers who are willing to take on various affirmative 
obligations in exchange for the opportunity to stand in a trading crowd 
and trade with and against other market participants. The various 
affirmative obligations are established by Exchange rules,\1\ including 
Rule 8.7 which, among other things, requires market-makers to ``engage 
* * * in dealings for his own account when there exists, or it is 
reasonably anticipated that there will exist, a lack of price 
continuity, a temporary disparity between the supply of and demand for 
a particular option contract, or a temporary distortion of the price 
relationships between option contracts of the same class.'' Rule 8.7.03 
imposes distribution of activity requirements on market-markers. Rule 
8.51 obligates market-makers to honor disseminated market quotes. In 
addition to being required to meet the above obligations, CBOE market-
makers are subject to plenary oversight and regulation by the CBOE.\2\ 
In short, the system of affirmative obligations and oversight embodied 
in CBOE Rules subjects market-makers to a great deal of responsibility, 
in order to assure the quality and liquidity of the CBOE markets.
---------------------------------------------------------------------------

    \1\ Congress intended that exchanges have the primary 
responsibility for the formulation and enforcement of the regulation 
of exchange market making. See Report of the Senate Banking, Housing 
and Urban Affairs Committee, Senate Report No. 94-75, April 14, 
1975, to accompany S. 249, at p. 15. Section 11(b) of the Exchange 
Act and Exchange Act Rule 11b-1 codify that policy. In fact, certain 
of the obligations imposed on CBOE market-makers by CBOE rules are 
mandated by Rule 11b-1.
    \2\ Exchange Act Rule 11b-1(a)(2)(v) requires to CBOE to have 
procedures ``to provide for effective and systematic surveillance of 
the activities'' of its market-makers.
---------------------------------------------------------------------------

    The CBOE believes that ``go along'' orders interfere with this 
obligation-opportunity trade-off of Exchange market-making. 
Essentially, those

[[Page 55664]]

market participants, generally professional traders, who enter ``go-
along'' orders are attempting to realize the opportunity of market-
making without accepting any of the obligations. In addition, by their 
nature, ``go along'' orders do not provide any incremental liquidity or 
price discovery because the market participant entering the ``go 
along'' order is merely trading at a price at which the market-makers 
were willing to trade. These market participants, as customers, 
however, are not obligated to fulfill any of the obligations of market-
makers and their activity is typically not subject to Commission or 
Exchange oversight. These orders can be entered from off the floor of 
the exchange and can be canceled at the complete discretion of the 
customer. Therefore, these orders dilute the participation of those 
market-makers who do provide liquidity on a continual basis both in 
good times and in bad.
    Likewise, common sense dictates these orders do not provide any 
price discovery. As explained further below, options are priced in an 
efficient market such as the CBOE by the skill of the individual 
market-makers and their ability to employ complex pricing models and 
strategies. ``Go along'' orders add nothing to this process, but simply 
piggyback on the expertise and experience of those participants who 
have taken on affirmative obligations and have put their capital at 
risk.
    The potential danger of this type of activity and any other 
activity that provides a disincentive to market-making is that this 
activity could lead to an irremediable decline of CBOE's existing 
market-making system and the protections to public investors that that 
system provides. It is hard work for CBOE market-makers to stand in 
crowds and fulfill their numerous obligations under Exchange rules. The 
regulation to which market-makers are subject may be necessary, but it 
is burdensome. If the rules of the Exchange allow a trader to send such 
orders from off the floor whenever he wants and to be able to cancel 
the orders at will, without having an affirmative obligation to stand 
behind any quotes and without being subject to oversight, more and more 
market-makers may decide to engage in such activity and forgo the 
numerous risks involved in market-making.\3\ The resultant decline in 
liquidity and capital would inevitably compromise the quality of CBOE's 
markets and harm the public. Ultimately, the proliferation of this type 
of activity could even threaten the viability of CBOE's markets. 
Ironically, these orders rely on the pricing efficiency of a market to 
be effective; yet, these orders interfere with that pricing efficiency.
---------------------------------------------------------------------------

    \3\ Although these orders have been employed for years, the 
possibility that market-makers might decide to forgo market-making 
to trade from off of the floor is greater now than ever before. The 
Commission's approval of risk-based haircuts has reduced the 
traditional advantages market-makers have had in the area of capital 
charges and margin. In addition, the technological advancement of 
order delivery systems continues to erode the time and place 
priority that has been one of the inducements to accepting the risks 
of market-making.
---------------------------------------------------------------------------

    Although a ``go along'' order may have some upper or lower limit 
price (but often it does not), the essence of a ``go along'' order is 
that it relies on the pricing of the market-makers in the crowd. A 
person entering a ``go along'' order, therefore, does not make any 
independent market judgment on the price of the option. It is the 
dependence upon the actions of the market-makers who establish the 
prices and provide liquidity that makes this type of order 
objectionable. Although market orders arguably also rely on the pricing 
of the market-makers, market orders do not provide a disincentive to 
market-making as ``go along'' orders do. Even if ``go along'' orders or 
similar orders were entered on the floor of the New York Stock Exchange 
or another stock exchange, the Exchange does not believe these orders 
would be as objectionable in the context of a stock exchange as they 
are on the CBOE options floor, because of the nature of the pricing of 
these difference securities. On any given market there is only one 
market (bid and offer) for a particular stock. The price is determined 
according to the fundamentals of the issuer and according to the 
principles of supply and demand for the shares of the stock. 
Conversely, for any given underlying stock, there may be markets for 
twenty or more different puts and calls. Because options are derivative 
securities, the markets on these puts and calls are affected by 
information about the markets for the underlying securities and related 
interests, but also by complex mathematical formulas and volatility 
assumptions. The pricing of options is a necessary and critical 
function performed by market-makers and because of the complexity 
involved and the individual assumptions required it is obviously a 
function for which market-makers take a proprietary interest. 
Therefore, the use of an order to replicate the actions of the market-
makers and to dilute their participation in a trade provides a 
disincentive to a market-maker to meet his affirmative obligations and 
to develop pricing formulas and strategies.
    The prohibition of these types of orders does not limit market 
accessibility.
    The Exchange understands the Commission's concern with ensuring the 
accessibility of public markets to orders from all market participants. 
The proposed prohibition would not be a prohibition against any 
category of market participants but against a type of activity that 
threatens the system itself. The prohibition would not limit access to 
CBOE markets to any person who has access to the market currently; any 
participant who currently employs ``go along'' orders would be entitled 
to enter limit orders, market orders, and any number of contingency 
orders. By specifying that the broker representing the order should 
trade with the market-makers in the crowd, the order ensures that these 
orders will be inaccessible to those market-makers.
    The restriction is also designed to assure equal regulation of and 
a fair competition among all persons making markets on the CBOE, thus 
serving these important purposes of the Act. Individuals sending these 
types of orders as a pattern of behavior are attempting to act as 
market-makers without fulfilling affirmative obligations. Any person 
who wishes to compete as a market-maker in CBOE securities can do so by 
becoming a CBOE member and subjecting himself to the same restrictions, 
obligations, and surveillance as every other CBOE market-maker. There 
is no burden on competition or unfair limit on market access to require 
all competitors to play by the same ground rules.
    The CBOE believes that its market-marker system has served and 
continues to serve the public well by providing deep and liquid markets 
for hundreds of classes of options listed on the Exchange. As a result, 
the Exchange believes it is appropriate to prohibit activity that 
threatens this system without any resulting public benefit.
2. Statutory Basis
    By prohibiting certain types of orders that interfere with the 
continued performance of the CBOE market-maker system and assuring 
equal regulation of and a fair competition among all persons making 
markets on the CBOE, CBOE believes that the proposed rule change is 
consistent with and furthers the objectives of Section 6(b)(5) of the 
Act \4\ in that it is designed to perfect the mechanisms of a free and 
open market and to protect investors and the public interest.
---------------------------------------------------------------------------

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

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

[[Page 55665]]

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

    The Exchange does not believe that the proposed rule change will 
impose any inappropriate burden on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    No written comments were either solicited or received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the publication of this notice in the Federal 
Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve the proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying at the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
Exchange. All submissions should refer to File No. SR-CBOE-97-50 and 
should be submitted by November 13, 1997.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-28307 Filed 10-24-97; 8:45 am]
BILLING CODE 8010-01-M