[Federal Register: January 31, 2007 (Volume 72, Number 20)]
[Notices]
[Page 4553-4555]
[DOCID:fr31ja07-112]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55153; File No. SR-Phlx-2006-74]

Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.;
Order Granting Approval to Proposed Rule Change as Modified by
Amendment Nos. 1 and 2 Thereto, Relating to a Pilot Program To Quote
Options in Penny Increments

January 23, 2007.

I. Introduction

    On November 13, 2006, the Philadelphia Stock Exchange, Inc.
(``Phlx'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to amend various Exchange rules
to permit certain option classes to be quoted in pennies on a pilot
basis. On November 22, 2006, the Exchange filed Amendment No. 1 to the
proposed rule change. The Exchange filed Amendment No. 2 to the
proposed rule change on December 5, 2006. The proposed rule change, as
modified by Amendment Nos. 1 and 2, was published for comment in the
Federal Register on December 13, 2006.\3\ The Commission received no
comment letters on the proposed rule change. This order approves the
proposed rule change as modified by Amendment Nos. 1 and 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 54886 (December 6,
2006), 71 FR 74979.
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II. Description of the Proposal

A. Scope of the Penny Pilot Program

    Phlx proposes to amend its rules to permit certain option classes
to be quoted in pennies during a six-month pilot (``Penny Pilot
Program''), which would commence on January 26, 2007. Specifically,
proposed Phlx Rule 1034(a)(i)(B) would set forth the parameters of the
Penny Pilot Program.
    Currently, all six options exchanges, including Phlx, quote options
in nickel and dime increments. The minimum price variation for
quotations in options series that are quoted at less than $3 per
contract is $0.05 and the minimum price variation for quotations in
options series that are quoted at $3 per contract or greater is $0.10.
Under the Penny Pilot Program, beginning on January 26, 2007, market
participants would be able to begin quoting in penny increments in
certain series of option classes.

    The Penny Pilot Program would include the following thirteen
options classes: Ishares Russell 2000 (IWM); NASDAQ-100 Index Tracking
Stock (QQQQ); SemiConductor Holders Trust (SMH); General Electric
Company (GE); Advanced Micro Devices, Inc. (AMD); Microsoft Corporation
(MSFT); Intel Corporation (INTC); Caterpillar, Inc. (CAT); Whole Foods
Market, Inc. (WFMI); Texas Instruments, Inc. (TXN); Flextronics
International Ltd. (FLEX); Sun Microsystems, Inc. (SUNW); and Agilent
Technologies, Inc. (A). The Exchange would communicate the list of
options to be included in the Penny Pilot Program to its membership via
Exchange circular.
    The minimum price variation for all classes included in the Penny
Pilot Program, except for the QQQQs, would be $0.01 for all quotations
in option series that are quoted at less than $3 per contract and $0.05
for all quotations in option series that are quoted at $3 per contract
or greater. The QQQQs would be quoted in $0.01 increments for all
options series.
    Proposed Phlx Rule 1034(a)(i)(C) would require the Exchange to
prepare and submit a report to the Commission during the fourth month
of the pilot, which would be composed of data from the first three
months of trading. The report would analyze the impact of penny quoting
on market quality and options systems capacity.

B. Automatic Executions During Crossed Markets

    The Exchange anticipates that the instance of crossed markets
(where the bid price is greater than the offer price) will increase in
options traded in penny increments. Accordingly, the Exchange proposes
to amend its rules concerning automatic executions during crossed
markets, and its rule \4\ providing exceptions from Trade-Through
liability when a Trade-Through occurs due to an automatic execution
when the Exchange's disseminated market is crossed, or crosses the
disseminated market of another options exchange, and the Exchange's
disseminated price on the opposite side of the market for the incoming
order establishes, or is equal to, the NBBO.
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    \4\ See Phlx Rule 1085(b)(10).
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    Currently, orders on the Exchange that are otherwise eligible for
automatic execution are handled manually by the specialist when the
Exchange's disseminated market is crossed by more than one minimum
quoting increment (as defined in Phlx Rule 1034) (i.e., 2.10 bid, 2
offer), or crosses the disseminated market of another options exchange
by more than one minimum quoting increment.\5\ The Exchange currently
provides automatic executions during crossed markets when the
Exchange's disseminated market is crossed by not more than one minimum
quoting increment, or crosses the disseminated market of another
options exchange by not more than one minimum quoting increment, and
the Exchange's disseminated price on the opposite side of the market
for the incoming order establishes, or is equal to, the NBBO.\6\ The
Exchange proposes to delete Phlx Rule 1080(c)(iv)(A), which would mean
that the Exchange would provide automatic executions in options where
the Exchange's disseminated market is the NBBO \7\ and is crossed, or
crosses the disseminated market of another options exchange, regardless
of the amount by which such market is crossed.\8\
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    \5\ See Phlx Rule 1080(c)(iv)(A).
    \6\ See Phlx Rule 1085(b)(10). See also Securities Exchange Act
Release No. 53449 (March 8, 2006), 71 FR 13441 (March 15, 2006) (SR-
Phlx-2005-45).
    \7\ The Exchange provides automatic executions only when its
disseminated market is the NBBO. See Phlx Rule 1080(c)(iv)(E).
    \8\ The Exchange notes that another options exchange currently
provides automatic executions during crossed markets regardless of
the amount by which the market is crossed. See Securities Exchange
Act Release No. 54229 (July 27, 2006), 71 FR 44058 (August 3, 2006)
(SR-CBOE-2005-90).
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C. Trade-Throughs

    Currently, Phlx Rule 1085(b) affords Exchange members several
exemptions from Trade-Through liability and the requirements under
Phlx's rules and the Plan for the Purpose of Creating and Operating an
Intermarket Option Linkage (``Linkage Plan'') concerning satisfaction
of Trade-Throughs. Among the exemptions from such liability and
satisfaction responsibility is current Phlx Rule 1085(b)(10), which
provides an exemption when the Trade-Through was the result of an
automatic execution when the Exchange's disseminated market is the NBBO
and is crossed by not more than one minimum quoting increment (as
defined in Phlx Rule 1034), or crosses the disseminated market of
another options exchange by not more than one minimum quoting
increment.\9\
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    \9\ The Commission exempted the Exchange from the requirement
under Rule 608(c) of Regulation NMS that Phlx comply, and enforce
compliance by its members, with Section 8(c) of Linkage Plan.
Section 8(c) of the Linkage Plan provides, in part, that, ``absent
reasonable justification and during normal market conditions,
members in [Participants'] markets should not effect Trade-
Throughs'' in the limited situation when transactions are the result
of an automatic execution when the Exchange's disseminated market is
the NBBO and is crossed by not more than one minimum trading
increment (as defined in Phlx Rule 1034), or crosses the
disseminated market of another options exchange by not more than one
minimum trading increment. See letter from Robert L.D. Colby to
Meyer S. Frucher, Chairman and Chief Executive Officer, Phlx, dated
March 8, 2006.
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    To be consistent with the proposed rule change (described above) to
provide automatic executions when the Exchange's disseminated market is
the NBBO regardless of the amount by which the market is crossed, the
Exchange proposes to amend Phlx Rule 1085(b)(10) to exempt from such
liability and satisfaction responsibility when the Trade-Through was
the result of an automatic execution when the Exchange's disseminated
market is the NBBO and is crossed, or crosses the disseminated market
of another options exchange. The proposed rule change would delete the
current language contained in Phlx Rule 1085(b)(10) that limits the
exemption from Trade-Through and satisfaction liability to automatic
executions at the NBBO during markets that are crossed by one minimum
trading increment.

D. Zero-Bid Option Series

    Currently, Phlx Rule 1080(i) states that the Exchange's AUTOM
System will convert market orders to sell a particular option series to
limit orders to sell with a limit price of $0.05 that are received when
the bid price for such series is zero. The proposal would amend Phlx
Rule 1080(i) to state that the system will convert such orders to limit
orders to sell with a limit price of the minimum quoting increment
applicable to such series. The effect of this with respect to options
quoted and traded in minimum increments of $0.01 would be that such
conversion would be to a limit order to sell at $0.01, rather than
$0.05.

E. Quote Mitigation

    To mitigate quote traffic, the Exchange proposes to amend Phlx Rule
1082, Firm Quotations, by adopting new Phlx Rule 1082(a)(ii)(C), which
would modify the Exchange's definition of ``disseminated size'' such
that the Exchange will disseminate fewer updated quotations.
    Specifically, proposed Phlx Rule 1082(a)(ii)(C) would set forth the
conditions under which the Exchange would disseminate updated
quotations based on changes in the Exchange's disseminated price and/or
size. The proposed rule would require the Exchange to disseminate an
updated bid and offer price, together with the size associated with
such bid and offer, when: (1) The Exchange's disseminated bid or offer
price increases or decreases; (2) the size associated with the

Exchange's disseminated bid or offer decreases; or (3) the size
associated with the Exchange's bid (offer) increases by an amount
greater than or equal to a percentage (never to exceed 20%) of the size
associated with the previously disseminated bid (offer). Such
percentage, which would never exceed 20%, would be determined on an
issue-by-issue basis by the Exchange and announced to membership via
Exchange circular. The percentage size increase necessary to give rise
to a refreshed quote may vary from issue to issue, depending, without
limitation, on the liquidity, average volume, and average number of
quotations submitted in the issue. Proposed Phlx Rule 1082(b)(ii)(C)
would not be limited to options included in the pilot, and would apply
to all options traded on the Exchange.
    The Exchange represents that participants on its system would not
be notified of any incremental increase in the size of the Exchange's
quote under proposed Phlx Rule 1082(a)(ii)(C)(3) until such quote is
disseminated to OPRA. Therefore, no participant on the Exchange's
system would have information that is unavailable to another
participant.

III. Discussion

    After careful review of the proposal, the Commission finds that the
proposed rule change, as modified by Amendment Nos. 1 and 2, is
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities
exchange.\10\ In particular, the Commission finds that the proposal is
consistent with Section 6(b)(5) of the Act,\11\ which requires, among
other things, that the rules of an exchange be designed to promote just
and equitable principles of trade, to remove impediments to and perfect
the mechanism of a free and open market and a national market system,
and, in general, to protect investors and the public interest.
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    \10\ In approving this proposed rule change the Commission notes
that it has considered the proposed rule's impact on efficiency,
competition, and capital formation. See 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that the implementation of a limited six-
month Penny Pilot Program by Phlx and the five other options exchanges
will provide valuable information to the exchanges, the Commission and
others about the impact of penny quoting in the options market. In
particular, the Penny Pilot Program will allow analysis of the impact
of penny quoting on: (1) Spreads; (2) transaction costs; (3) payment
for order flow; and (4) quote message traffic.
    The Commission believes that the thirteen options classes to be
included in the penny pilot program represent a diverse group of
options classes with varied trading characteristics. This diversity
should facilitate analyses by the Commission, the options exchanges and
others. The Commission also believes that the Penny Pilot Program is
sufficiently limited that it is unlikely to increase quote message
traffic beyond the capacity of market participants' systems and disrupt
the timely receipt of quote information.
    Nevertheless, because the Commission expects that the Penny Pilot
Program will increase quote message traffic, the Commission is
simultaneously approving the Exchange's proposals to reduce the number
of quotations it disseminates.\12\
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    \12\ In addition to the quote mitigation proposal discussed
herein, Phlx also proposed other quote mitigation strategies. See
e.g., Securities Exchange Act Release No. 54648 (October 24, 2006),
71 FR 63375 (October 30, 2006) (SR-Phlx-2006-52); No. 54807
(November 21, 2006), 71 FR 69173 (November 29, 2006) (SR-Phlx-2006-
53); 54859 (December 1, 2006), 71 FR 71605 (December 11, 2006) (SR-
Phlx-2006-51); 54914 (December 11, 2006), 71 FR 75798 (December 18,
2006) (SR-Phlx-2006-81).
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    In addition, the Commission believes that Phlx's proposed deletion
of Phlx Rule 1080(c)(iv)(A) and proposed conforming changes to Phlx
Rule 1085(b)(10) is consistent with the Act and will facilitate the
prompt resolution of crossed markets by permitting automatic executions
when the Exchange's disseminated market is the NBBO and is crossed, or
crosses the disseminated market of another options exchange, regardless
of the amount by which the market is crossed.\13\
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    \13\ The exemption Phlx received from the requirement under Rule
608(c) of Regulation NMS that Phlx comply, and enforce compliance by
its members, with Section 8(c) of Linkage Plan regarding trade-
throughs on March 8, 2006 (see note 9, supra) was limited to
transactions when the market was crossed by one minimum trading
increment. Therefore, Phlx submitted an exemption request to expand
the scope of the exemption to include trade-throughs resulting from
automatic executions while the Exchange's disseminated market is
crossed, or crosses the disseminated market of another options
exchange, and the Exchange's disseminated price on the opposite side
of the market for the incoming order establishes, or is equal to,
the NBBO, regardless of the amount by which the market is crossed.
See letter from Richard S. Rudolph, Vice President and Counsel,
Chairman and Chief Executive Officer, Phlx, to Nancy M. Morris,
Secretary, Commission, dated January 19, 2006. The Commission
granted this exemption request on January 23, 2007. See letter from
Elizabeth K. King, Associate Director, Commission, to Richard S.
Rudolph, Vice President and Counsel, Phlx, dated January 23, 2006.
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    Finally, the Commission believes that it is consistent with the Act
for Phlx to update its rule governing Zero-Bid Options Series to
provide that the system will convert such orders to limit orders to
sell with a limit price of the minimum quoting increment applicable to
such series, in order that options quoted and traded in minimum
increments of $0.01 pursuant to the Penny Pilot Program would convert
to a limit order to sell at $0.01, rather than $0.05.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\14\ that the proposed rule change (SR-Phlx-2006-74), as modified
by Amendment Nos. 1 and 2, be, and hereby is, approved on a six month
pilot basis, which will commence on January 26, 2007.
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    \14\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-1508 Filed 1-30-07; 8:45 am]

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