Order Granting an Exemption for Qualified Contingent Trades From Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 1934, 52829-52831 [E6-14806]
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Federal Register / Vol. 71, No. 173 / Thursday, September 7, 2006 / Notices
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NASD. Therefore, modifications to the
Certification need not be filed with the
Commission as an amendment to the
Plan, provided that the Parties are only
adding to, deleting from, or confirming
changes to NYSE Arca rules in the
Certification in conformance with the
definition of Common Rules provided in
the Plan. However, should NYSE Arca
or NASD decide to add a NYSE Arca
rule to the Certification that is not
substantially similar to an NASD rule;
delete a NYSE Arca rule from the
Certification that is substantially similar
to an NASD rule; or leave on the
Certification a NYSE Arca rule that is no
longer substantially similar to an NASD
rule, then such a change would
constitute an amendment to the Plan,
which must be filed with the
Commission pursuant to Rule 17d–2
under the Act and noticed for public
comment.
As noted above, NYSE Arca and
NASD have also set forth in the
Certification the Federal securities laws,
and the rules and regulations
thereunder, for which NASD will bear
responsibility under the Plan for
examining, and enforcing compliance
by, common members. The Commission
notes that any changes to this list of
Federal securities laws, and the rules
and regulations thereunder, would
constitute an amendment to the Plan,
which must be filed with the
Commission pursuant to Rule 17d–2
under the Act and noticed for public
comment.
The Plan also permits NYSE Arca and
NASD to terminate the Plan, subject to
notice, for various reasons. The
Commission notes, however, that while
the Plan permits the Parties to terminate
the Plan, the Parties cannot by
themselves reallocate the regulatory
responsibilities set forth in the Plan,
since Rule 17d–2 under the Act requires
that any allocation or re-allocation of
regulatory responsibilities be filed with
the Commission.21
III. Conclusion
This Order gives effect to the Plan
filed with the Commission in File No.
4–523. The Parties shall notify all
members affected by the Plan of their
rights and obligations under the Plan.
It is therefore ordered, pursuant to
Sections 17(d) and 11A(a)(3)(B) of the
Act, that the Plan in File No. 4–523,
between NYSE Arca and NASD, filed
pursuant to Rule 17d–2 under the Act,
is approved and declared effective.
21 The Commission notes that paragraphs 3 and
13 of the Plan reflect the fact that NASD’s
responsibilities under the Plan will continue in
effect until the Commission approves the
termination of the Plan.
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It is therefore ordered that NYSE Arca
is relieved of those responsibilities
allocated to the NASD under the Plan in
File No. 4–523.
For the Commission, by the Division of
Market Regulation, pursuant to delegated
authority.22
Jill M. Peterson,
Assistant Secretary.
[FR Doc. E6–14784 Filed 9–6–06; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–54389]
Order Granting an Exemption for
Qualified Contingent Trades From Rule
611(a) of Regulation NMS Under the
Securities Exchange Act of 1934
August 31, 2006.
I. Introduction
Pursuant to Rule 611(d) 1 of
Regulation NMS 2 under the Securities
Exchange Act of 1934 (‘‘Exchange Act’’),
the Securities and Exchange
Commission (‘‘Commission’’), by order,
may exempt from the provisions of Rule
611 of Regulation NMS (‘‘Rule 611’’ or
‘‘Rule’’), either unconditionally or on
specified terms and conditions, any
person, security, transaction, quotation,
or order, or any class or classes of
persons, securities, quotations, or
orders, if the Commission determines
that such exemption is necessary or
appropriate in the public interest, and is
consistent with the protection of
investors.3 As discussed below, the
Commission is exempting each NMS
stock component of certain qualified
contingent trades (as defined below)
from Rule 611(a) of Regulation NMS.
II. Background
The Commission adopted Regulation
NMS in June 2005. 4 Rule 611 addresses
intermarket trade-throughs of quotations
in NMS stocks.5 The Rule applies only
to quotations that are immediately
accessible through automatic execution.
22 17
CFR 200.30–3(a)(34).
CFR 242.611(d).
2 17 CFR 242.600 et seq.
3 See also 15 U.S.C. 78mm(a)(1) (providing
general authority for Commission to grant
exemptions from provisions of Exchange Act and
rules thereunder).
4 See Securities Exchange Act Release No. 51808
(June 9, 2005), 70 FR 37496 (June 29, 2005)
(‘‘Regulation NMS Adopting Release’’).
5 An ‘‘NMS stock’’ means any security or class of
securities, other than an option, for which
transaction reports are collected, processed, and
made available pursuant to an effective transaction
reporting plan. See 17 CFR 242.600(b)(46) and (47).
52829
The Securities Industry Association
(‘‘SIA’’) has requested that the
Commission exempt certain qualified
contingent trades from Rule 611(a) of
Regulation NMS.6 According to the SIA
Exemption Request, a contingent trade
‘‘is a multi-component trade involving
orders for a security and a related
derivative, or, in the alternative, orders
for related securities, that are executed
at or near the same time.’’ 7 The SIA
notes that the economics of a contingent
trade are based on the relationship
between the prices of the security and
the related derivative or security, and
that the execution of one order is
contingent upon the execution of the
other order. The SIA states that the
sought-after spread or ratio between the
relevant instruments is known and
specified at the time of the order, and
this spread or ratio stands regardless of
the prevailing price at the time of
execution. Therefore, the parties to
these transactions are focused on the
spread or ratio between the transaction
prices for each of the component
instruments, rather than on the absolute
price of any single component
instrument. Because the focus of such
trades is on the relative prices of the
component instruments, the price of a
component of a particular trade may or
may not correspond to the prevailing
market price of the security. For
contingent trades, the parties to the
trade will not execute one side of the
trade without the other component or
components being executed in full (or in
ratio) and at the specified spread or
ratio.8
The SIA states that contingent trades
play an important role in the investment
and trading strategies of investors. They
are the mechanism through which large
institutional and broker-dealer
proprietary traders enter and exit the
market for many securities, including
those that are involved in a merger,
those representing different classes of
shares of the same issuer, those with
convertible securities that are related to
the common stock, and those with
actively traded equity derivatives such
as options.9 The SIA believes that, as a
general rule, the market view on what
constitutes an appropriate spread or
1 17
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Sfmt 4703
6 Letter to Nancy M. Morris, Secretary,
Commission, from Andrew Madoff, SIA Trading
Committee, SIA, dated June 21, 2006 (‘‘SIA
Exemption Request’’).
7 SIA Exemption Request at 2.
8 See SIA Exemption Request at 2.
9 See SIA Exemption Request at 2. In an appendix
to its letter, the SIA provided detailed discussions
of three types of contingent trades, namely, a risk
or merger arbitrage transaction, a convertible
security transaction, and a stock option transaction,
and how these trades would be affected by Rule
611. See SIA Exemption Request at 8–12.
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ratio between related securities is less
volatile than the quoted prices for the
stocks that are part of these contingent
trades and, consequently, contingent
trades act as a stabilizing factor in the
markets.10
To effectively execute a contingent
trade, its component orders must be
executed in full or in ratio 11 at its
predetermined spread or ratio.
According to the SIA, parties seeking to
effect contingent trades involving NMS
stocks in many instances would be able
to comply with the Rule, but in other
instances—such as trades involving two
or more NMS stocks or circumstances in
which there was insufficient flexibility
to adjust the execution price of the nonNMS stock component of a contingent
trade—compliance with Rule 611 would
not be possible. In such instances, if the
designated price of an NMS stock that
was a component order of a proposed
contingent trade was inferior to a
protected bid or offer, as relevant, the
Rule would require the better protected
bids or offers to be satisfied prior to the
execution of the NMS stock component
of the contingent trade, thus preventing
the trade from being executed in
accordance with the original terms. The
SIA believes that, by breaking up one or
more components of the contingent
trade and requiring that such
component(s) be separately executed
from the entire trade package and at
prices inappropriate for the desired
trading strategy, Rule 611 would
effectively undermine the contingent
aspect of the trade and leave one or
more parties to the trade ‘‘out of
hedge.’’ 12
Without an exemption from Rule 611,
the SIA believes that customers might
be unable to complete contingent trades.
In particular, dealers might be unable to
commit capital to those customers who
requested it, which could reduce or
eliminate this type of trading activity
and remove liquidity from the market.
The SIA believes that such a result
would disadvantage the market as a
whole.13
In its exemption request, the SIA
states that the requested relief is
narrowly drawn, noting that the number
of qualified contingent trades is small in
comparison to the overall number of
trades executed in NMS stocks. It
therefore believes that the number of
possible exempted trade-throughs
would similarly be small. The SIA also
10 See
SIA Exemption Request at 2–3.
ratio’’ clarifies that component orders of a
contingent trade do not necessarily have to be
executed in full, but any partial executions must be
in a predetermined ratio.
12 See SIA Exemption Request at 3.
13 See SIA Exemption Request at 4.
11 ‘‘In
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noted that the requirement that the NMS
stock component of a contingent trade
be of block size further reduces the risk
that the exemption will used
inappropriately for transactions of retail
size.14
III. Discussion
After careful consideration and for the
reasons discussed below, the
Commission hereby grants an
exemption from Rule 611(a) for any
trade-throughs caused by the execution
of an order involving one or more NMS
stocks (each an ‘‘Exempted NMS Stock
Transaction’’) that are components of a
qualified contingent trade. A ‘‘qualified
contingent trade’’ is a transaction
consisting of two or more component
orders, executed as agent or principal,
where:
(1) At least one component order is in
an NMS stock;
(2) 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;
(3) The execution of one component
is contingent upon the execution of all
other components at or near the same
time;
(4) 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;
(5) 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; 15
(6) The 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; 16 and
(7) The Exempted NMS Stock
Transaction that is part of a contingent
trade involves at least 10,000 shares or
14 See
SIA Exemption Request at 6.
involving securities of
participants in mergers or with intentions to merge
that have been announced would meet this aspect
of the requested exemption. Transactions involving
cancelled mergers, however, would constitute
qualified contingent trades only to the extent they
involve the unwinding of a pre-existing position in
the merger participants’ shares. Statistical arbitrage
transactions, absent some other derivative or merger
arbitrage relationship between component orders,
would not satisfy this element of the definition of
a qualified contingent trade.
16 A trading center may demonstrate that an
Exempted NMS Stock Transaction is fully hedged
under the circumstances based on the use of
reasonable risk-valuation methodologies.
15 Transactions
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Fmt 4703
Sfmt 4703
has a market value of at least
$200,000.17
The Commission notes that a trading
center must meet all of the foregoing
elements of a qualified contingent trade
to qualify for the exemption. The
exemption is not restricted to dealers or
the over-the-counter market. It can be
used by any trading center that meets
the terms of the exemption.
Rule 611 requires trading centers to
establish, maintain, and enforce written
policies and procedures that are
reasonably designed to prevent tradethroughs, or, if relying on one of the
Rule’s exceptions, that are reasonably
designed to assure compliance with the
exception.18 In addition, a trading
center is required to regularly surveil to
ascertain the effectiveness of its policies
and procedures and to take prompt
action to remedy deficiencies.19 The
Rule also includes a number of
exceptions, such as intermarket sweep
orders 20 and orders executed at
‘‘benchmark’’ prices that were not
reasonably determinable at the time the
commitment to execute the order was
made.21 Without an exemption,
however, qualified contingent trades
generally would be subject to the Rule.
As discussed in the Regulation NMS
Adopting Release, the Commission
previously considered comments
favoring a general exception from the
Rule for broad categories of transactions,
variously described as ‘‘contingency’’
transactions, ‘‘arbitrage’’ transactions,
‘‘spread’’ transactions, and transactions
priced with reference to derivatives.22 It
noted, however, that any exception for
such a broad category of transactions
potentially could unduly detract from
the objectives of Rule 611. Therefore,
when adopting Regulation NMS, the
Commission stated that the most
appropriate process to handle
suggestions that specific types of
transactions should be excluded from
the coverage of the Rule would be
through the exemptive procedure set
forth in paragraph (d) of the Rule.
The Commission recognizes that
contingent trades can be useful trading
tools for investors and other market
participants, particularly those who
trade the securities of issuers involved
in mergers, different classes of shares of
the same issuer, convertible securities,
and equity derivatives such as options.
17 See 17 CFR 242.600(b)(9) (defining ‘‘block size’’
with respect to an order as at least 10,000 shares
or $200,000 in market value).
18 See 17 CFR 242.611(a)(1).
19 See 17 CFR 242.611(a)(2).
20 See 17 CFR 242.611(b)(5) and (6).
21 See 17 CFR 242.611(b)(7).
22 Regulation NMS Adopting Release, 70 FR at
37528.
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Federal Register / Vol. 71, No. 173 / Thursday, September 7, 2006 / Notices
Those who engage in contingent trades
can benefit the market as a whole by
studying the relationships between the
prices of such securities and executing
contingent trades when they believe
such relationships are out of line with
what they believe to be fair value.
Contingent trades therefore are one
example of a wide variety of trades that
contribute to the efficient functioning of
the securities markets and the price
discovery process. The Commission
believes that qualified contingent trades
potentially could become too risky and
costly to be employed successfully if
they were required to meet the tradethrough provisions of Rule 611. Absent
an exemption, participants in
contingent trades often would need to
use the Rule’s intermarket sweep order
exception and route orders to execute
against protected quotations with better
prices than an NMS stock component of
the contingent trade. Any executions of
these routed orders could throw the
participants ‘‘out of hedge’’ and
necessitate additional transactions in an
attempt to correct the imbalance. As a
practical matter, the difficulty of
maintaining a hedge, and the risk of
falling out of hedge, could dissuade
participants from engaging in contingent
trades, or at least raise the cost of such
trades. The elimination or reduction of
this trading strategy potentially could
remove liquidity from the market. The
Commission therefore has determined to
exempt qualified exempted trades from
Rule 611.
To minimize the effect of an
exemption on the objectives of Rule 611,
the exemption is narrowly drawn to
encompass only those trades most in
need of relief to remain part of a viable
trading strategy and where execution of
the NMS stock component at a tradethrough price is reasonably necessary to
effect the contingent trade. In particular,
elements (1) through (6) of the
exemption, as set forth above, require a
close connection between any Exempted
NMS Stock Transaction and the other
components of a qualified contingent
trade. This close connection should
both significantly limit the number of
Exempted NMS Stock Transactions and
help assure that the exemption applies
only to those trades most in need of
flexibility to be executed efficiently. For
example, the execution of one
component of the transaction must be
contingent upon the execution of all
other components at or near the same
time, and the Exempted NMS Stock
Transaction must be fully hedged
(without regard to any prior existing
position) as a result of the other
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18:11 Sep 06, 2006
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components of the contingent trade.23 In
addition, there must be a specified
relationship between the instruments
involved in the component orders. The
component orders must 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.24 The
exemption does not apply to contingent
trades, such as statistical arbitrage
transactions, if their components do not
involve instruments with a specified
relationship. Finally, the Exempted
NMS Stock Transaction must be of
block-size, involving at least 10,000
shares or having a market value of at
least $200,000. This element further
limits the exemption to those
transactions where an exemption is
likely to be most needed to facilitate the
trading strategies of informed
customers.
Accordingly, the exemption should
provide appropriate relief in those
circumstances where compliance with
Rule 611 could be most difficult as a
practical matter, but also is limited to a
small number of transactions that
should not unduly undermine the
objectives of Rule 611.25 In this regard,
the Commission notes that the
exception is premised on an expectation
that qualified contingent trades will
continue to be used for essentially the
same valid trading purposes as they are
currently and as described in the SIA
Exemption Request. A material change
in the nature or frequency of such trades
could cause the Commission to
reconsider the terms of the exemption.
For the foregoing reasons, the
Commission finds that granting an
exemption from Rule 611 for qualified
contingent trades, as defined above, is
necessary and appropriate in the public
interest, and is consistent with the
protection of investors.
23 The requirement that an Exempted NMS Stock
Transaction be fully hedged should significantly
limit the scope of the exemption. For example, a
contingent trade would not qualify for the
exemption if an NMS stock transaction was the
purchase or sale of 50,000 shares, and the only
other component was the purchase or sale of a
small quantity of options on the NMS stock. A
trading center may demonstrate that an Exempted
NMS Stock Transaction is fully hedged under the
circumstances based on the use of reasonable riskvaluation methodologies.
24 Transactions involving cancelled mergers
would be qualified contingent trades only to the
extent that they involve the unwinding of a preexisting position in the merger participants’ shares.
25 See SIA Exemption Request at 5–6
(representing that the number of qualified
contingent trades is small in comparison to the
overall number of trades executed in NMS stocks
and, therefore, the overall number of possible
exempted trade-throughs is similarly small).
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Fmt 4703
Sfmt 4703
52831
IV. Conclusion
It is hereby ordered, pursuant to Rule
611(d) of Regulation NMS, that each
NMS stock component of qualified
contingent trades, as defined above,
shall be exempt from Rule 611(a) of
Regulation NMS.
For the Commission, by the Division of
Market Regulation, pursuant to delegated
authority.26
Nancy M. Morris,
Secretary.
[FR Doc. E6–14806 Filed 9–6–06; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–54386; File No. SR–Amex–
2006–75]
Self-Regulatory Organizations;
American Stock Exchange LLC; Notice
of Filing and Immediate Effectiveness
of Proposed Rule Change Relating to
the Extension of a Pilot Program That
Increases Position and Exercise Limits
for Equity Options and Options on the
Nasdaq-100 Tracking Stock
August 30, 2006.
Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934
(‘‘Act’’) 1 and Rule 19b–4 thereunder,2
notice is hereby given that on August
15, 2006, the American Stock Exchange
LLC (‘‘Amex’’ or ‘‘Exchange’’) filed with
the Securities and Exchange
Commission (‘‘Commission’’) the
proposed rule change as described in
Items I and II below, which Items have
been prepared by the Amex. The
Exchange has filed the proposal as a
‘‘non-controversial’’ rule change
pursuant to Section 19(b)(3)(A) of the
Act 3 and Rule 19b–4(f)(6) thereunder,4
which renders it effective upon filing
with the Commission. 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 Exchange seeks a six-month
extension of its pilot program increasing
the standard position and exercise
limits for options on the QQQQ and
equity option classes traded on the
Exchange (‘‘Pilot Program’’). The text of
the proposed rule change is available on
the Amex’s Web site (https://
26 17
CFR 200.30–3(a)(82).
U.S.C. 78s(b)(1).
2 17 CFR 240.19b–4.
3 15 U.S.C. 78s(b)(3)(A).
4 17 CFR 240.19b–4(f)(6).
1 15
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]]>Agencies
[Federal Register Volume 71, Number 173 (Thursday, September 7, 2006)]
[Notices]
[Pages 52829-52831]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-14806]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-54389]
Order Granting an Exemption for Qualified Contingent Trades From
Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 1934
August 31, 2006.
I. Introduction
Pursuant to Rule 611(d) \1\ of Regulation NMS \2\ under the
Securities Exchange Act of 1934 (``Exchange Act''), the Securities and
Exchange Commission (``Commission''), by order, may exempt from the
provisions of Rule 611 of Regulation NMS (``Rule 611'' or ``Rule''),
either unconditionally or on specified terms and conditions, any
person, security, transaction, quotation, or order, or any class or
classes of persons, securities, quotations, or orders, if the
Commission determines that such exemption is necessary or appropriate
in the public interest, and is consistent with the protection of
investors.\3\ As discussed below, the Commission is exempting each NMS
stock component of certain qualified contingent trades (as defined
below) from Rule 611(a) of Regulation NMS.
---------------------------------------------------------------------------
\1\ 17 CFR 242.611(d).
\2\ 17 CFR 242.600 et seq.
\3\ See also 15 U.S.C. 78mm(a)(1) (providing general authority
for Commission to grant exemptions from provisions of Exchange Act
and rules thereunder).
---------------------------------------------------------------------------
II. Background
The Commission adopted Regulation NMS in June 2005. \4\ Rule 611
addresses intermarket trade-throughs of quotations in NMS stocks.\5\
The Rule applies only to quotations that are immediately accessible
through automatic execution.
---------------------------------------------------------------------------
\4\ See Securities Exchange Act Release No. 51808 (June 9,
2005), 70 FR 37496 (June 29, 2005) (``Regulation NMS Adopting
Release'').
\5\ An ``NMS stock'' means any security or class of securities,
other than an option, for which transaction reports are collected,
processed, and made available pursuant to an effective transaction
reporting plan. See 17 CFR 242.600(b)(46) and (47).
---------------------------------------------------------------------------
The Securities Industry Association (``SIA'') has requested that
the Commission exempt certain qualified contingent trades from Rule
611(a) of Regulation NMS.\6\ According to the SIA Exemption Request, a
contingent trade ``is a multi-component trade involving orders for a
security and a related derivative, or, in the alternative, orders for
related securities, that are executed at or near the same time.'' \7\
The SIA notes that the economics of a contingent trade are based on the
relationship between the prices of the security and the related
derivative or security, and that the execution of one order is
contingent upon the execution of the other order. The SIA states that
the sought-after spread or ratio between the relevant instruments is
known and specified at the time of the order, and this spread or ratio
stands regardless of the prevailing price at the time of execution.
Therefore, the parties to these transactions are focused on the spread
or ratio between the transaction prices for each of the component
instruments, rather than on the absolute price of any single component
instrument. Because the focus of such trades is on the relative prices
of the component instruments, the price of a component of a particular
trade may or may not correspond to the prevailing market price of the
security. For contingent trades, the parties to the trade will not
execute one side of the trade without the other component or components
being executed in full (or in ratio) and at the specified spread or
ratio.\8\
---------------------------------------------------------------------------
\6\ Letter to Nancy M. Morris, Secretary, Commission, from
Andrew Madoff, SIA Trading Committee, SIA, dated June 21, 2006
(``SIA Exemption Request'').
\7\ SIA Exemption Request at 2.
\8\ See SIA Exemption Request at 2.
---------------------------------------------------------------------------
The SIA states that contingent trades play an important role in the
investment and trading strategies of investors. They are the mechanism
through which large institutional and broker-dealer proprietary traders
enter and exit the market for many securities, including those that are
involved in a merger, those representing different classes of shares of
the same issuer, those with convertible securities that are related to
the common stock, and those with actively traded equity derivatives
such as options.\9\ The SIA believes that, as a general rule, the
market view on what constitutes an appropriate spread or
[[Page 52830]]
ratio between related securities is less volatile than the quoted
prices for the stocks that are part of these contingent trades and,
consequently, contingent trades act as a stabilizing factor in the
markets.\10\
---------------------------------------------------------------------------
\9\ See SIA Exemption Request at 2. In an appendix to its
letter, the SIA provided detailed discussions of three types of
contingent trades, namely, a risk or merger arbitrage transaction, a
convertible security transaction, and a stock option transaction,
and how these trades would be affected by Rule 611. See SIA
Exemption Request at 8-12.
\10\ See SIA Exemption Request at 2-3.
---------------------------------------------------------------------------
To effectively execute a contingent trade, its component orders
must be executed in full or in ratio \11\ at its predetermined spread
or ratio. According to the SIA, parties seeking to effect contingent
trades involving NMS stocks in many instances would be able to comply
with the Rule, but in other instances--such as trades involving two or
more NMS stocks or circumstances in which there was insufficient
flexibility to adjust the execution price of the non-NMS stock
component of a contingent trade--compliance with Rule 611 would not be
possible. In such instances, if the designated price of an NMS stock
that was a component order of a proposed contingent trade was inferior
to a protected bid or offer, as relevant, the Rule would require the
better protected bids or offers to be satisfied prior to the execution
of the NMS stock component of the contingent trade, thus preventing the
trade from being executed in accordance with the original terms. The
SIA believes that, by breaking up one or more components of the
contingent trade and requiring that such component(s) be separately
executed from the entire trade package and at prices inappropriate for
the desired trading strategy, Rule 611 would effectively undermine the
contingent aspect of the trade and leave one or more parties to the
trade ``out of hedge.'' \12\
---------------------------------------------------------------------------
\11\ ``In ratio'' clarifies that component orders of acontingent
trade do not necessarily have to be executed in full, but any
partial executions must be in a predetermined ratio.
\12\ See SIA Exemption Request at 3.
---------------------------------------------------------------------------
Without an exemption from Rule 611, the SIA believes that customers
might be unable to complete contingent trades. In particular, dealers
might be unable to commit capital to those customers who requested it,
which could reduce or eliminate this type of trading activity and
remove liquidity from the market. The SIA believes that such a result
would disadvantage the market as a whole.\13\
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\13\ See SIA Exemption Request at 4.
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In its exemption request, the SIA states that the requested relief
is narrowly drawn, noting that the number of qualified contingent
trades is small in comparison to the overall number of trades executed
in NMS stocks. It therefore believes that the number of possible
exempted trade-throughs would similarly be small. The SIA also noted
that the requirement that the NMS stock component of a contingent trade
be of block size further reduces the risk that the exemption will used
inappropriately for transactions of retail size.\14\
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\14\ See SIA Exemption Request at 6.
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III. Discussion
After careful consideration and for the reasons discussed below,
the Commission hereby grants an exemption from Rule 611(a) for any
trade-throughs caused by the execution of an order involving one or
more NMS stocks (each an ``Exempted NMS Stock Transaction'') that are
components of a qualified contingent trade. A ``qualified contingent
trade'' is a transaction consisting of two or more component orders,
executed as agent or principal, where:
(1) At least one component order is in an NMS stock;
(2) 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;
(3) The execution of one component is contingent upon the execution
of all other components at or near the same time;
(4) 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;
(5) 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; \15\
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\15\ Transactions involving securities of participants in
mergers or withintentions to merge that have been announced would
meet this aspect of the requested exemption. Transactions involving
cancelled mergers, however, would constitute qualified contingent
trades only to the extent they involve the unwinding of a pre-
existing position in the merger participants' shares. Statistical
arbitrage transactions, absent some other derivative or merger
arbitrage relationship between component orders, would not satisfy
this element of the definition of a qualified contingent trade.
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(6) The 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; \16\ and
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\16\ A trading center may demonstrate that an Exempted NMS
StockTransaction is fully hedged under the circumstances based on
the use of reasonable risk-valuation methodologies.
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(7) The Exempted NMS Stock Transaction that is part of a contingent
trade involves at least 10,000 shares or has a market value of at least
$200,000.\17\
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\17\ See 17 CFR 242.600(b)(9) (defining ``block size'' with
respect to an order as at least 10,000 shares or $200,000 in market
value).
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The Commission notes that a trading center must meet all of the
foregoing elements of a qualified contingent trade to qualify for the
exemption. The exemption is not restricted to dealers or the over-the-
counter market. It can be used by any trading center that meets the
terms of the exemption.
Rule 611 requires trading centers to establish, maintain, and
enforce written policies and procedures that are reasonably designed to
prevent trade-throughs, or, if relying on one of the Rule's exceptions,
that are reasonably designed to assure compliance with the
exception.\18\ In addition, a trading center is required to regularly
surveil to ascertain the effectiveness of its policies and procedures
and to take prompt action to remedy deficiencies.\19\ The Rule also
includes a number of exceptions, such as intermarket sweep orders \20\
and orders executed at ``benchmark'' prices that were not reasonably
determinable at the time the commitment to execute the order was
made.\21\ Without an exemption, however, qualified contingent trades
generally would be subject to the Rule.
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\18\ See 17 CFR 242.611(a)(1).
\19\ See 17 CFR 242.611(a)(2).
\20\ See 17 CFR 242.611(b)(5) and (6).
\21\ See 17 CFR 242.611(b)(7).
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As discussed in the Regulation NMS Adopting Release, the Commission
previously considered comments favoring a general exception from the
Rule for broad categories of transactions, variously described as
``contingency'' transactions, ``arbitrage'' transactions, ``spread''
transactions, and transactions priced with reference to
derivatives.\22\ It noted, however, that any exception for such a broad
category of transactions potentially could unduly detract from the
objectives of Rule 611. Therefore, when adopting Regulation NMS, the
Commission stated that the most appropriate process to handle
suggestions that specific types of transactions should be excluded from
the coverage of the Rule would be through the exemptive procedure set
forth in paragraph (d) of the Rule.
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\22\ Regulation NMS Adopting Release, 70 FR at 37528.
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The Commission recognizes that contingent trades can be useful
trading tools for investors and other market participants, particularly
those who trade the securities of issuers involved in mergers,
different classes of shares of the same issuer, convertible securities,
and equity derivatives such as options.
[[Page 52831]]
Those who engage in contingent trades can benefit the market as a whole
by studying the relationships between the prices of such securities and
executing contingent trades when they believe such relationships are
out of line with what they believe to be fair value.
Contingent trades therefore are one example of a wide variety of
trades that contribute to the efficient functioning of the securities
markets and the price discovery process. The Commission believes that
qualified contingent trades potentially could become too risky and
costly to be employed successfully if they were required to meet the
trade-through provisions of Rule 611. Absent an exemption, participants
in contingent trades often would need to use the Rule's intermarket
sweep order exception and route orders to execute against protected
quotations with better prices than an NMS stock component of the
contingent trade. Any executions of these routed orders could throw the
participants ``out of hedge'' and necessitate additional transactions
in an attempt to correct the imbalance. As a practical matter, the
difficulty of maintaining a hedge, and the risk of falling out of
hedge, could dissuade participants from engaging in contingent trades,
or at least raise the cost of such trades. The elimination or reduction
of this trading strategy potentially could remove liquidity from the
market. The Commission therefore has determined to exempt qualified
exempted trades from Rule 611.
To minimize the effect of an exemption on the objectives of Rule
611, the exemption is narrowly drawn to encompass only those trades
most in need of relief to remain part of a viable trading strategy and
where execution of the NMS stock component at a trade-through price is
reasonably necessary to effect the contingent trade. In particular,
elements (1) through (6) of the exemption, as set forth above, require
a close connection between any Exempted NMS Stock Transaction and the
other components of a qualified contingent trade. This close connection
should both significantly limit the number of Exempted NMS Stock
Transactions and help assure that the exemption applies only to those
trades most in need of flexibility to be executed efficiently. For
example, the execution of one component of the transaction must be
contingent upon the execution of all other components at or near the
same time, and the Exempted NMS Stock Transaction must be fully hedged
(without regard to any prior existing position) as a result of the
other components of the contingent trade.\23\ In addition, there must
be a specified relationship between the instruments involved in the
component orders. The component orders must 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.\24\ The exemption does not apply to contingent trades, such
as statistical arbitrage transactions, if their components do not
involve instruments with a specified relationship. Finally, the
Exempted NMS Stock Transaction must be of block-size, involving at
least 10,000 shares or having a market value of at least $200,000. This
element further limits the exemption to those transactions where an
exemption is likely to be most needed to facilitate the trading
strategies of informed customers.
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\23\ The requirement that an Exempted NMS Stock Transaction be
fullyhedged should significantly limit the scope of the exemption.
For example, a contingent trade would not qualify for the exemption
if an NMS stock transaction was the purchase or sale of 50,000
shares, and the only other component was the purchase or sale of a
small quantity of options on the NMS stock. A trading center may
demonstrate that an Exempted NMS Stock Transaction is fully hedged
under the circumstances based on the use of reasonable risk-
valuation methodologies.
\24\ Transactions involving cancelled mergers would be
qualifiedcontingent trades only to the extent that they involve the
unwinding of a pre-existing position in the merger participants'
shares.
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Accordingly, the exemption should provide appropriate relief in
those circumstances where compliance with Rule 611 could be most
difficult as a practical matter, but also is limited to a small number
of transactions that should not unduly undermine the objectives of Rule
611.\25\ In this regard, the Commission notes that the exception is
premised on an expectation that qualified contingent trades will
continue to be used for essentially the same valid trading purposes as
they are currently and as described in the SIA Exemption Request. A
material change in the nature or frequency of such trades could cause
the Commission to reconsider the terms of the exemption.
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\25\ See SIA Exemption Request at 5-6 (representing that the
number of qualified contingent trades is small in comparison to the
overall number of trades executed in NMS stocks and, therefore, the
overall number of possible exempted trade-throughs is similarly
small).
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For the foregoing reasons, the Commission finds that granting an
exemption from Rule 611 for qualified contingent trades, as defined
above, is necessary and appropriate in the public interest, and is
consistent with the protection of investors.
IV. Conclusion
It is hereby ordered, pursuant to Rule 611(d) of Regulation NMS,
that each NMS stock component of qualified contingent trades, as
defined above, shall be exempt from Rule 611(a) of Regulation NMS.
For the Commission, by the Division of Market Regulation, pursuant
to delegated authority.\26\
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\26\ 17 CFR 200.30-3(a)(82).
Nancy M. Morris,
Secretary.
[FR Doc. E6-14806 Filed 9-6-06; 8:45 am]
BILLING CODE 8010-01-P
