Self-Regulatory Organizations; Chicago Board Options Exchange, Incorporated; Notice of Filing of Proposed Rule Change Relating to Tied Hedge Transactions, 9115-9121 [E9-4287]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 74, Number 39 (Monday, March 2, 2009)]
[Notices]
[Pages 9115-9121]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-4287]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-59435; File No. SR-CBOE-2009-007]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Proposed Rule Change Relating to Tied 
Hedge Transactions

February 23, 2009.
    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 February 13, 2009, the Chicago Board Options Exchange, Incorporated 
(``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 
Exchange. The Commission is publishing this notice to solicit comments 
on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to adopt Interpretation and Policy .10 to 
Rule 6.74, Crossing Orders, to allow hedging stock, security future or 
futures contract positions to be represented currently with option 
facilitations or solicitations in the trading crowd (``tied hedge'' 
orders). The text of the proposed rule change is available on the 
Exchange's Web site (https://www.cboe.org/Legal), 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, CBOE included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed

[[Page 9116]]

rule change. The text of these statements may be examined at the places 
specified in Item IV below. CBOE 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 Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Rule 6.74 generally sets forth the procedures by which a floor 
broker may cross an order with a contra-side order. Transactions 
executed pursuant to Rule 6.74 are subject to the restrictions of 
paragraph (e) of Rule 6.9, Solicited Transactions, which prohibits 
trading based on knowledge of imminent undisclosed solicited 
transactions (commonly referred to as ``anticipatory hedging'').
Existing Anticipatory Hedge Rule
    By way of background, when Rule 6.9 was adopted in 1994, the 
Exchange noted its belief that it is appropriate to permit solicitation 
between potential buyers and sellers of options in advance of the time 
they send actual orders to the trading crowd on the Exchange. The 
Exchange also noted that complex orders, such as spreads, straddles, 
combination and stock-option orders, often require the ``advance 
shopping'' that is characteristic of a solicited transaction, and that 
such interactions between buyers and sellers and the resulting 
solicited transactions can enhance liquidity and depth at the CBOE by 
bringing orders to the floor that might otherwise be difficult to 
effect. While recognizing this, Exchange also noted that, if the orders 
that comprise a solicited transaction are not suitably exposed to the 
order interaction process on the CBOE floor, the execution of such 
orders would not be consistent with CBOE rules designed to promote 
order interaction in an open-outcry auction.\3\ Solicited transactions 
by definition entail negotiation, and if the orders that comprise a 
solicited transaction are not adequately exposed to the floor auction, 
the in-crowd market participants (e.g., Market-Makers in the trading 
crowd) cannot have sufficient time to digest and react to those orders' 
terms. The pre-negotiation inherent in the solicitation process thus 
can enable the parties to a solicited transaction to preempt the crowd 
to an execution at the pre-negotiated price. Thus, the Exchange notes, 
Rule 6.9 was originally designed to preserve the right to solicit 
orders in advance of submitting a proposed trade to the crowd, while at 
the same time assuring that orders that are the subject of a 
solicitation are exposed to the auction market in a meaningful way. In 
addition to requiring disclosure of orders and clarifying the priority 
principles applicable to solicited transactions,\4\ Rule 6.9 provides 
that it is inconsistent with just and equitable principles of trade for 
any member or associated person, who has knowledge of all the material 
terms of an original order \5\ and a solicited order (including a 
facilitation order) that matches the original order's price, to enter 
an order to buy or sell an option of the same class as any option that 
is the subject of the solicitation prior to the time the original 
order's terms are disclosed to the crowd or the execution of the 
solicited transaction can no longer reasonably be considered imminent. 
This prohibition extends to orders to buy or sell the underlying 
security or any ``related instrument,'' as that term is defined in the 
rule.\6\
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    \3\ For example, Rule 6.43, Manner of Bidding and Offering, 
requires bids and offers to be made at the post by public outcry, 
and Rule 6.74 imposes specific order exposure requirements on floor 
brokers seeking to cross buy orders with sell orders.
    \4\ For example, the rule requires that the member or member 
organization representing an original order that is the subject of a 
solicitation to disclose the terms of the original order to the 
crowd before the original order can be executed. This disclosure is 
intended to eliminate the unfairness that can be associated with 
pre-negotiated transactions among the parties to the solicitation 
versus the in-crowd market participants, and would subject the order 
that is the subject of the solicitation to full auction interaction 
with other orders in the crowd. In addition, priority is accorded 
depending on whether the original order is disclosed throughout the 
solicitation period; whether the solicited order improves the best 
bid or offer in the trading crowd; and whether the solicited order 
matches the original order's limit. Rule 6.74(d) contains exceptions 
to these priority provisions in instances were a crossing 
participation entitlement is sought.
    \5\ An ``original order'' is an order respecting an option 
traded on the Exchange, including a spread, combination, straddle, 
stock option, security-future-option or any other complex order. See 
Rule 6.9.
    \6\ For purposes of Rule 6.9(e), an order to buy or sell a 
``related instrument,'' means, ``in reference to an index option, an 
order to buy or sell securities comprising ten percent or more of 
the component securities in the index or an order to buy or sell a 
futures contract on any economically equivalent index. With respect 
to an SPX option, an OEX option is a related instrument, and vice 
versa.''
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    When originally adopted in 1994, the CBOE believed that the 
prohibition on anticipatory hedging was necessary to prevent members 
and associated persons from using undisclosed information about 
imminent solicited option transactions to trade the relevant option or 
any closely-related instrument in advance of persons represented in the 
relevant options crowd. CBOE believes the basic principle remains true 
today, but changes in the marketplace have caused CBOE to re-evaluate 
the effectiveness and efficiency of CBOE's existing rule's procedural 
requirements, as well as CBOE's previous objections to an exception 
proposed by another exchange for its proposed equivalent rule in 
2003.\7\ Since that time, the Exchange believes that increased 
volatility in the markets, as well as the advent of penny trading in 
underlying stocks and resultant decreased liquidity at the top of each 
underlying market's displayed national best bid or offer, it has become 
increasingly difficult for members and member organizations to assess 
ultimate execution prices and the extent of available stock to hedge 
related options facilitation/solicitation activities, and to manage 
that market risk. This risk extends to simple and complex orders, and 
to all market participants involved in the transaction (whether 
upstairs or on-floor) because of the uncertainty of the extent to which 
the market participant will participate in the transaction, the amount 
of time associated with the auction process, and the likelihood that 
the underlying stock prices in today's environment may be difficult to 
assess and change before they are able to hedge. These circumstances 
make it difficult to obtain a hedge, difficult to quote orders and 
difficult to achieve executions, and can translate into less liquidity 
in the form of smaller size and wider quote spreads, fewer 
opportunities for price improvement, and the inefficient handling of 
orders. Additionally, more and more trading activity appears to be 
taking place away from the exchange-listed environment and in the over-
the-counter (``OTC'') market, which by its nature is not subject to the 
same trade-through type risks present in the exchange environment. 
Therefore, the Exchange is seeking to make its trading rules more 
efficient not only to address the market risk and execution concerns, 
but also to effectively compete with and attract volume from the OTC 
market. What is more, Market-Makers' trading strategies have evolved. 
Whereas before

[[Page 9117]]

Market-Makers tended to trade based on delta risk,\8\ now market-making 
strategy is based more on volatility.\9\ The tied hedge transaction 
procedures (described below) are designed in a way that is consistent 
with this shift toward a volatility trading strategy, and makes it more 
desirable for Market-Makers to compete for orders that are exposed 
through the solicitation process.
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    \7\ CBOE's proposed exception is similar to an exception that 
had been proposed in 2003 by the Philadelphia Stock Exchange 
(``Phlx''). See Securities Exchange Act Release No. 48875 (December 
4, 2003), 68 FR 70072 (December 16, 2003) (SR-Phlx-2003-75). At the 
time of the Phlx proposal, which was ultimately not pursued to 
approval, CBOE commented that the proposal should not be approved 
unless certain amendments were made. For example, CBOE suggested 
that the tied hedge procedures should be limited to scenarios where 
the order cannot be satisfied by the displayed national best bid or 
offer (``NBBO'') or, for similar reasons, the order is of a 
significantly larger than average size. See letters from Edward J. 
Joyce, President and Chief Operating Officer, CBOE, to Jonathan G. 
Katz, Secretary, Commission, dated January 14, 2004 and May 20, 
2004; see also note 15, infra.
    \8\ The price of an option is not completely dependent on supply 
and demand, nor on the price of the underlying security. Market-
Makers price options based on basic measures of risk as well. One of 
these such measures, delta, is the rate of change in the price of an 
option as it relates to changes in the price of the underlying 
security, security future or futures contract. The delta of an 
option is measured incrementally based on movement in the price of 
the underlying security, security future or futures contract. For 
example, if the price of an option increases or decreases by $1.00 
for each $1.00 increase or decrease in the price of the underlying 
security, the option would have a delta of 100. If the price of an 
option increases or decreases by $0.50 for each $1.00 increase or 
decrease in the price of the underlying security, the option would 
have a delta of 50.
    \9\ Volatility is a measure of the fluctuation in the underlying 
security's market price. Market-Makers that trade based on 
volatility have options positions that they hedge with the 
underlying. Once hedged, the risk exposure to the Market-Maker is 
realized volatility and implied volatility. Realized volatility is 
the actual volatility in the underlying. Implied volatility is 
determined by using option prices currently existing in the market 
at the time rather than using historical data on the market price 
changes of the underlying.
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    In order to address the concerns associated with increased 
volatility and decreased liquidity and more effectively compete with 
the OTC market, the Exchange is proposing to adopt a limited exception 
to the anticipatory hedging restrictions that would permit the 
representation of hedging stock positions in conjunction with option 
orders, including complex orders, in the options trading crowd (a 
``tied hedge'' transaction). The Exchange believes this limited 
exception remains in keeping with the original design of Rule 6.9(e), 
but sets forth a more practicable approach considering today's trading 
environment that will provide the ability to hedge in a way that will 
still encourage meaningful competition among upstairs and floor 
traders. Besides stock positions, the proposal would also permit 
security futures positions to be used has a hedge. In addition, in the 
case where the order is for options on indices, options on exchange-
traded funds (``ETF'') or options on HOLding Company Depository 
ReceiptS (``HOLDRS''), a related instrument may be used as a hedge. A 
``related instrument'' would mean, in reference to an index option, 
securities comprising ten percent or more of the component securities 
in the index or a futures contract on any economically equivalent index 
applicable to the option order. With respect to SPX, OEX would be an 
economically equivalent index, and vice versa.\10\ A ``related 
instrument'' would mean, in reference to an ETF or HOLDR option, a 
futures contract on any economically equivalent index applicable to the 
ETF or HOLDR underlying the option order.\11\
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    \10\ The proposed definition of a ``related instrument'' with 
respect to an index option is modeled after the definition that 
currently applies under Rule 6.9(e). See proposed Rule 6.74.10(c)(i) 
and note 6, supra.
    \11\ For example, a tied hedge order involving options on the 
iShares Russell 2000 Index ETF might involve a hedge position in the 
underlying ETF, security futures overlying the ETF, or futures 
contracts overlying the Russell 2000 Index.
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    With a tied hedge transaction, Exchange members would be permitted 
to first hedge an option order with the underlying security, a security 
future or futures contract, as applicable, and then forward the option 
order and the hedging position to an Exchange floor broker with 
instructions to represent the option order together with the hedging 
position to the options trading crowd. The in-crowd market participants 
that chose to participate in the option transaction must also 
participate in the hedging position. First, under the proposal, the 
original option order must be in a class designated as eligible for a 
tied hedge transaction as determined by the Exchange, including FLEX 
Options classes.\12\ The original option order must also be within 
designated tied hedge eligibility size parameters, which would be 
determined by the Exchange and would not be smaller than 500 
contracts.\13\ The Exchange notes that the minimum order size would 
apply to an individual original order.\14\ Multiple original orders 
could not be aggregated to satisfy the requirement (though multiple 
contra-side solicited orders could be aggregated to execute against the 
original order). The Exchange states that the primary purpose of this 
provision is to limit use of the tied hedge procedures to larger orders 
that might benefit from a member's or member organization's ability to 
execute a facilitating hedge.\15\ Assuming an option order meets these 
eligibility parameters, the proposal also includes a number of other 
conditions that must be satisfied.
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    \12\ FLEX Options provide investors with the ability to 
customize basic option features including size, expiration date, 
exercise style, and certain exercise prices.
    \13\ The designated classes and minimum order size applicable to 
each class would be communicated to the membership via Regulatory 
Circular. For example, the Exchange could determine to make the tied 
hedge transaction procedures available in options class XYZ for 
orders of 1,000 contracts or more. Such a determination would be 
announced via Regulatory Circular, which would include a cumulative 
list of all classes and corresponding sizes for which the tied hedge 
procedures are available.
    \14\ In determining whether an individual original order 
satisfies the eligible order size requirement, any complex order 
must contain one leg alone which is for the eligible order size or 
greater. This approach to the eligible order size requirement for 
complex orders is analogous to Rule 6.74(d)(iii), which provides 
that a complex order must contain one leg alone which is for the 
eligible order size or greater to be eligible for an open outcry 
crossing entitlement.
    \15\ As discussed above in note 7, in commenting on the prior 
Phlx proposal, CBOE suggested that the tied hedge procedures should 
be limited to scenarios where the order cannot be satisfied by the 
NBBO or, for similar reasons, the order is of a significantly larger 
than average size. CBOE's reasoning was that there may not be as 
much benefit to delaying the representation and execution of smaller 
orders that may be immediately fillable or executed more quickly by 
sending an order to the options crowd (as opposed to tying up such 
an order with stock). See CBOE Letter II at 3-4. Particularly given 
the decreased amount of liquidity available at the NBBO, the 
frequency with which quotes may flicker, and differing costs 
associated with accessing liquidity on various markets, as well as 
for ease of administration, the Exchange believes that its proposed 
500 contract minimum is sufficient to address these considerations. 
The Exchange intends to evaluate whether 500 contracts is the 
appropriate threshold and whether smaller sized orders may benefit 
from the procedures. If any reduction in the eligible size is 
desired, the Exchange would submit a separate rule filing on this 
subject in the future.
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    Second, the proposal would also require that, prior to entering 
tied hedge orders on behalf of customers, the member or member 
organization must deliver to the customer a one-time written 
notification informing the customer that his order may be executed 
using the Exchange's tied hedge procedures. Under the proposal, the 
written notification must disclose the terms and conditions contained 
in the proposed rule and be in a form approved by the Exchange. Given 
the minimum size requirement of 500 contracts per order, the Exchange 
believes that use of the tied hedges procedures will generally consist 
of orders for the accounts of institutional or sophisticated, high net 
worth investors. The Exchange therefore believes that a one-time 
notification delivered by the member or member organization to the 
customer would be sufficient, and that an order-by-order notification 
would be unnecessary and overly burdensome.
    Third, a member or member organization would be required to create 
an electronic record that it is engaging in a tied hedge order in a 
form and manner prescribed by the Exchange. The Exchange states that 
the purpose of this provision is to create a record to ensure that 
hedging trades would be appropriately associated with the related 
options order and appropriately

[[Page 9118]]

evaluated in the Exchange's surveillance program. The Exchange believes 
that this requirement should enable the Exchange to monitor for 
compliance with the requirements of the proposed rule, as discussed 
below, by identifying the specific purchase or sell orders relating to 
the hedging position.
    Fourth, the proposed rule would require that members and member 
organizations that have decided to engage in tied hedge orders for 
representation in the trading crowd would have to ensure that the 
hedging position associated with the tied hedge order is comprised of a 
position that is designated as eligible for a tied hedge transaction. 
Eligible hedging positions would be determined by the Exchange for each 
eligible class and may include (i) the same underlying stock applicable 
to the option order, (ii) a security future overlying the same stock 
applicable to the option order, or (iii) in reference to an option on 
an index, ETF or HOLDR, a ``related instrument'' (as described above). 
For example, for options overlying XYZ stock, the Exchange may 
determine to designate the underlying XYZ stock or XYZ security futures 
or both as eligible hedging positions.\16\ The Exchange states that the 
purpose of this provision is to ensure that the hedging position would 
be for the same stock, equivalent security future or related 
instrument, as applicable, thus allowing crowd participants who may be 
considering participation in a tied hedge order to adequately evaluate 
the risk associated with the option as it relates to the hedge. With 
stock positions in particular, the Exchange notes that occasionally 
crowd participants hedge option positions with stock that is related to 
the option, such as the stock of an issuer in the same industry, but 
not the actual stock associated with the option. Except as otherwise 
discussed above for index options, the proposed rule change would not 
allow such a ``related'' hedging stock position, but would require the 
hedging stock position to be the actual security underlying the option.
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    \16\ As with designated classes and minimum order size, the 
eligible hedging positions applicable to each class would be 
communicated to the membership via Regulatory Circular, which would 
include a cumulative list of all classes and corresponding sizes for 
which the tied hedge procedures are available. See note 13, supra.
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    Fifth, the proposal would require that the entire hedging position 
be brought without undue delay to the trading crowd. In considering 
whether the hedging position is presented without ``undue delay,'' the 
Exchange believes that members and member organizations should continue 
to have the same ability to shop an order in advance of presenting it 
to the crowd and should be able to enhance that process through 
obtaining a hedge. The Exchange also believes that, once a hedge is 
obtained, the order should be brought to the crowd promptly in order to 
satisfy the ``undue delay'' requirement. In addition, the proposal 
would require that the hedging position be announced to the trading 
crowd concurrently with the option order, offered to the crowd in its 
entirety, and offered at the execution price received by the member or 
member organization introducing the order to any in-crowd market 
participant who has established parity or priority for the related 
options. In-crowd market participants that participate in the option 
transaction must also participate in the hedging position on a 
proportionate basis \17\ and would not be permitted to prevent the 
option transaction from occurring by giving a competing bid or offer 
for one component of the tied hedge order. The Exchange states that the 
purpose of these requirements is to ensure that the hedging position 
represented to the crowd would be a good faith effort to provide in-
crowd market participants with the same opportunity as the member or 
member organization introducing the tied hedge order to compete most 
effectively for the option order.
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    \17\ For example, if an in-crowd market participant's allocation 
is 100 contracts out of a 500 contract option order (\1/5\), the 
same in-crowd market participant would trade 10,000 shares of a 
50,000 stock hedge position tied to that option order (\1/5\).
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    For example, if a member or member organization introducing a tied 
stock hedge order were to offer 1,000 XYZ option contracts to the crowd 
(overlying 100,000 shares of XYZ stock) and concurrently offer only 
30,000 of 100,000 shares of the underlying stock that the member 
obtained as a hedge, crowd participants might only be willing or able 
to participate in 300 of the option contracts offered if the hedging 
stock position cannot be obtained at a price as favorable as the stock 
hedging position offering price, if at all. The Exchange states that 
the effect of this would be to place the crowd at a disadvantage 
relative to the introducing member or member organization for the 
remaining 700 option contracts in the tied stock hedge order, and thus 
create a disincentive for the crowd to bid or offer competitively for 
the remaining 700 option contracts. The Exchange believes the 
requirement that the hedging position be presented concurrently with 
the option order in the crowd and offered to the crowd in its entirety 
at the execution price received by the member or member organization 
introducing the order should ensure that the crowd would be competing 
on a level playing field with the introducing member or member 
organization to provide the best price to the customer.
    Sixth, the proposal would require that the hedging position not 
exceed the options order on a delta basis. For example, in the 
situation where a tied stock hedge order involves the simultaneous 
purchase of 50,000 shares of XYZ stock and the sale of 500 XYZ call 
contract (known as a ``buy-write''), and the delta of the option is 
100, it would be considered ``hedged'' by 50,000 shares of stock. 
Accordingly, the proposed rule would not allow the introducing member 
firm to purchase more than 50,000 shares of stock in the hedging stock 
position. The Exchange believes that it is reasonable to require that 
the hedging position be in amounts that do not exceed the equivalent 
size of the related options order on a delta basis, and not for a 
greater number of shares. The Exchange believes that the proposed rule 
change would support its view that the member or member organization 
introducing the tied hedge order be guided by the notion that any 
excess hedging activity could be detrimental to the eventual execution 
price of the option order. Consequently, while delta estimates may vary 
slightly, the introducing member or member organization would be 
required to assume hedging positions not to exceed the equivalent size 
of the options order on a delta basis.\18\
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    \18\ The Exchange notes that there may be scenarios were the 
introducing member purchases (sells) less than the delta, e.g., when 
there is not enough stock is available to buy (sell) at the desired 
price. In such scenarios, the introducing member would present the 
stock that was purchased (sold) and share it with the in-crowd 
market participants on equal terms. This risk of obtaining less than 
a delta hedge is a risk that exists under the current rules because 
of the uncertainty that exists when market participants price an 
option and have to anticipate the price at which they will be able 
to obtain a hedge. The proposed tied hedge procedures are designed 
to help reduce this risk, but the initiating member may still be 
unable to execute enough stock at the desired price. To the extent 
the initiating member is able to execute any portion of the hedge, 
the risk exposure to the initiating member and in-crowd market 
participants would be diminished because those shares would be 
``tied up'' and available for everyone that participates on the 
resulting tied hedge transaction. The Exchange does not believe that 
the initiating member would have an unfair advantage by having the 
ability to pre-facilitate less than a delta hedge because the 
proposed procedures would require the in-crowd market participants 
to get a proportional share of the hedge. To the extent more stock 
is needed to complete a hedge, the initiating member and the in-
crowd market participants would have the same risk exposure that 
they do today.

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[[Page 9119]]

    The Exchange believes that the delta basis requirement, together 
with the additional conditions that an introducing member or member 
organization bring the hedging position without undue delay to the 
trading crowd and announce it concurrently with the option order, offer 
it to the crowd in its entirety, and offer it at the execution price 
received by the member or member organization to any in-crowd market 
participant who has established parity or priority, will help assure 
that the hedging activity is bona fide and not for speculative or 
manipulative purposes. Additionally, the Exchange believes these 
conditions will help assure that there is no adverse effect on the 
auction market because, as discussed above, in-crowd market 
participants will have the same opportunity as the member or member 
organization introducing the tied hedge order to compete for the option 
order and will share the same benefits of limiting the market risk 
associated with hedging. The Exchange believes that customers will also 
benefit if the market risks are limited in the manner proposed. Once an 
original order is hedged, there is no delta risk. With the delta risk 
minimized, quotes will likely narrow as market participants (whether 
upstairs or on-floor) are better able to hedge and compete for orders. 
For example, Market-Makers could more easily quote markets to trade 
against a customer's original order based on volatility with the delta 
risk minimized, which would ultimately present more price improvement 
opportunities to the original order.\19\
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    \19\ The Exchange also believes that the proposed exception to 
the anticipatory hedging procedures will assist in the Exchange's 
competitive efforts to attract order flow from the OTC market, which 
may result in increased volume on the exchange markets.
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    At this time, the Exchange is not proposing any special priority 
provisions applicable to tied hedge transactions, though it intends to 
evaluate whether such changes are desired and may submit a separate 
rule filing on this subject in the future. Under the instant proposal, 
all tied hedge transactions will be treated as complex orders 
(regardless of whether the original order was a simple or complex 
order). Priority will be afforded in accordance with the Exchange's 
existing open outcry allocation and reporting procedures for complex 
orders.\20\ Any resulting tied hedge transactions will also be subject 
to the existing NBBO trade-through requirements for options and stock, 
as applicable. In this regard, the Exchange believes that the resulting 
option and stock components of the tied hedge transactions may qualify 
for various NBBO trade through exceptions including, for example, the 
complex trade exception to the Options Linkage Program \21\ and the 
qualified contingent trade exception to Rule 611(a) of Regulation NMS 
for the stock component.\22\
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    \20\ Generally, a complex order may be expressed in any 
increment and executed at a net debit or credit price with another 
member without giving priority to equivalent bids (offers) in the 
individual series legs that are represented in the trading crowd or 
in the public customer options limit order book provided at least 
one leg of the order betters the corresponding bid (offer) in the 
public customer options limit order book. For stock-option orders 
and security future-option orders, this means that the options leg 
of the order has priority over bids (offers) of the trading crowd 
but not over bids (offers) in the public customer options limit 
order book. In addition, for complex orders with non-option leg(s), 
such as stock-option orders, a bid or offer is made and accepted 
subject to certain other conditions, including that the options 
leg(s) may be cancelled at the request of any member that is a party 
to the transaction if market conditions in any non-CBOE market(s) 
prevent the execution of the non-options leg(s) at the agreed 
price(s). See, e.g., CBOE Rules 6.42, Minimum Increments for Bids 
and Offers, 6.45, Priority of Bids and Offers--Allocation of Trades, 
6.45A(b), Allocation of Orders Represented in Open Outcry (for 
equity options), 6.45B(b), Allocation of Orders Represented in Open 
Outcry (for index options and options on ETFs), 6.48, Contract Made 
on Acceptance of Bid or Offer, and 6.74. Any crossing participation 
entitlement would also apply to the tied hedge procedures in 
accordance with Rule 6.74(d).
    \21\ A ``complex trade'' is defined as: (i) The execution of an 
order in an option series in conjunction with the execution of one 
or more related orders in different option series in the same 
underlying security occurring at or near the same time in a ratio 
that is equal to or greater than one-to-three (.333) and less than 
or equal to three-to-one (3.0) and for the purpose of executing a 
particular investment strategy; or (ii) the execution of a stock 
option order to buy or sell a stated number of units of an 
underlying stock or a security convertible into the underlying stock 
(``convertible security'') coupled with the purchase or sale of 
option contract(s) on the opposite side of the market representing 
either (A) the same number of units of the underlying stock or 
convertible security, or (B) the number of units of the underlying 
stock or convertible security necessary to create a delta neutral 
position, but in no case in a ratio greater than 8 option contracts 
per unit of trading of the underlying stock or convertible security 
established for that series by the Options Clearing Corporation. See 
paragraph (4) of CBOE Rule 6.80, Definitions (applicable to Options 
Intermarket Linkage), and subparagraph (b)(7) to CBOE Rule 6.83, 
Order Protection.
    \22\ A ``qualified contingent trade'' is defined as a 
transaction consisting of two or more component orders, executed as 
agent or principal, where: (i) At least one component order is in an 
NMS stock; (ii) all components are effected with a product or price 
contingency that either has been agreed to by the respective 
counterparties or arranged for by a broker-dealer as principal or 
agent; (iii) the execution of one component is contingent upon the 
execution of all other components at or near the same time; (iv) the 
specific relationship between the component orders (e.g., the spread 
between the prices of the component orders) is determined at the 
time the contingent order is placed; (v) the component orders bear a 
derivative relationship to one another, represent different classes 
of shares of the same issuer, or involve the securities of 
participants in mergers or with intentions to merge that have been 
announced or since cancelled; and (vi) any trade-throughs caused by 
the execution of an order involving one or more NMS stocks (each an 
``Exempted NMS Stock Transaction) is fully hedged (without regard to 
any prior existing position) as a result of the other components of 
the contingent trade. See Securities Exchange Act Release No. 57620 
(April 4, 2008), 73 FR 19271 (April 9, 2008).
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    The Exchange recognizes that, at the time a tied hedge transaction 
is executed in a trading crowd, market conditions in any of the non-
CBOE market(s) may prevent the execution of the non-options leg(s) at 
the price(s) agreed upon. For example, the execution price may be 
outside the non-CBOE market's best bid or offer (``BBO''), e.g., the 
stock leg is to be executed at a price of $25.03 and the particular 
stock market's BBO is $24.93-$25.02, and such an execution would 
normally not be permitted unless an exception applies that permits the 
trade to be reported outside the BBO. The Exchange notes that the 
possibility of this scenario occurring exists with complex order 
executions today and tied hedge transactions would present nothing 
unique or novel in this regard. In the event the conditions in the non-
CBOE market continue to prevent the execution of the non-option leg(s) 
at the agreed price(s), the trade representing the options leg(s) of 
the tied hedge transaction may ultimately be cancelled in accordance 
with CBOE's existing rules.\23\
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    \23\ See paragraph (b) to CBOE Rule 6.48. The Exchange notes 
that, in the event of a cancellation, members may be exposed to the 
risk associated with holding the hedge position. The Exchange 
intends to address this point in a circular to members should the 
Exchange receive approval of this proposal.
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    The following examples illustrate these priority principles:
     Simple Original Order: Introducing member receives an 
original customer order to buy 500 XYZ call options, which has a delta 
of 100. The introducing member purchases 50,000 shares of XYZ stock on 
the NYSE for an average price of $25.03 per share. Once the stock is 
executed on the NYSE, the introducing member, without undue delay, 
announces the 500 contract option order and 50,000 share tied stock 
hedge at $25.03 per share to the CBOE trading crowd.
     Complex Original Order: Introducing member receives an 
original customer stock-option order to buy 500 XYZ call options and 
sell 50,000 shares of XYZ stock. The introducing member purchases 
50,000 shares of XYZ stock on the NYSE for an average price of $25.03 
per share. Once the stock is executed on the NYSE, the introducing

[[Page 9120]]

member, without undue delay, announces the 500 contract option order 
and 50,000 share tied stock hedge at $25.03 per share to the trading 
crowd.
    In either the simple or complex order scenario, the next steps are 
the same and are no different from the procedures currently used to 
execute a complex order on CBOE in open outcry.
     The in-crowd market participants would have an opportunity 
to provide competing quotes for the tied hedge package (and not for the 
individual component legs of the package). For example, assume the best 
net price is $24.53 (equal to $0.50 for each option contract and $25.03 
for each corresponding share of hedging stock).
     The option order and hedging stock would be allocated 
among the in-crowd market participants that established priority or 
parity at that price, including the initiating member, in accordance 
with the allocation algorithm applicable to the options class, with the 
options leg being executed and reported on the CBOE and the stock leg 
being executed and reported on the stock market specified by the 
initiating member. For example, the introducing member might trade 40% 
pursuant to an open outcry crossing entitlement (200 options contracts 
and 20,000 shares of stock) and the remaining balance might be with 
three different Market-Makers that each participated on 20% of the 
order (100 options contracts and 10,000 shares of stock per Market-
Maker).
     The resultant tied hedge transaction: (i) Would qualify as 
a ``complex trade'' under the Options Intermarket Linkage and the 
execution of the 500 option contracts with the market participants 
would not be subject to the NBBO for the particular option series; and 
(ii) would qualify as a ``qualified contingent trade'' under Regulation 
NMS and the execution of the 30,000 shares of stock (the original 
50,000 shares less the initiating member's 20,000 portion) with the 
market participants would not be subject to the NBBO for the underlying 
XYZ stock.
     The execution of the options leg would have to satisfy 
CBOE's intra-market priority rules for complex orders (including that 
the execution price may not be outside the CBOE BBO). Thus, if the CBOE 
BBO for the series was $0.40-$0.55, the execution could take place at 
or inside that price range (e.g., at the quoted price of $0.50) and 
could not take place outside that price range (e.g., not at $0.56).
     Similarly, the execution of the stock at $25.03 per share 
would have to satisfy the intra-market priority rules of the non-CBOE 
market(s) where the stock is to be executed (including that the 
execution price may not be outside that market's BBO) or, 
alternatively, qualify for an exception that permits the trade to be 
reported outside the non-CBOE market(s)' BBO.
     If market conditions in the non-CBOE market(s) prevent the 
execution of the stock leg(s) at the price(s) agreed upon from 
occurring (e.g., the BBO remains at $24.93-$25.02), then the options 
leg(s) could be cancelled at the request of any member that is a party 
to that trade.\24\
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    \24\ Id.
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    While the particular circumstances surrounding each transaction on 
the Exchange's trading floor are different, the Exchange does not 
believe, as a general proposition, that the tied hedge procedures would 
be inherently harmful or detrimental to customers or have an adverse 
effect on the auction market. Rather, the Exchange believes the 
procedures will improve the opportunities for an order to be exposed to 
a competitive auction and represent an improvement over the current 
rules. The fact that the parties to such a trade end up fully hedged 
may contribute to the best execution of the orders,\25\ and, in any 
event, participants continue to be governed by, among other things, 
their best execution responsibilities. The Exchange also believes that 
the proposed tied hedge procedures are fully consistent with the 
original design of Rule 6.9 which, as discussed above, was to eliminate 
the unfairness that can be associated with a solicited transaction and 
encourage meaningful competition. The tied hedge procedures will keep 
in-crowd market participants on equal footing with solicited parties in 
a manner that minimizes all parties' market risk while continuing to 
assure that orders are exposed in a meaningful way.
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    \25\ As market participants are better able to hedge risk 
associated with completing these transactions, the Exchange believes 
that quotes may narrow and result in increased price improvement 
opportunities.
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2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b) of the Act,\26\ in general, and furthers the 
objectives of Section 6(b)(5) of the Act,\27\ in particular, because it 
is designed to promote just and equitable principles of trade, to 
foster cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities, 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, 
by establishing rules governing tied hedge orders, which include 
specific requirements and procedures to be followed. Specifically, the 
Exchange believes the procedures will improve the opportunities for an 
order to be exposed to price improvement in a manner that will 
encourage a fair, competitive auction process and minimize all parties' 
market risk.
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    \26\ 15 U.S.C. 78f(b).
    \27\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    CBOE does not believe that the proposed rule change will impose any 
burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

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

    No written comments were solicited or received with respect to the 
proposed rule change.

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

    Within 35 days of the date of 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 Exchange 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, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (https://
www.sec.gov/rules/sro.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File No. SR-CBOE-2009-007 on the subject line.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary,

[[Page 9121]]

Securities and Exchange Commission, Station Place, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-CBOE-2009-007. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (https://www.sec.gov/rules/
sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room, on official business 
days between the hours of 10 a.m. and 3 p.m. Copies of such filing also 
will be available for inspection and copying at the principal office of 
the Exchange. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
CBOE-2009-007 and should be submitted on or before March 23, 2009.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-4287 Filed 2-27-09; 8:45 am]
BILLING CODE 8011-01-P