SEC no-action letter: CBOEdirect Screen Based Trading System application of Rule 11a2-2(T)

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March 31, 2003

Angelo Evangelou Senior Attorney Chicago Board Options Exchange 400 South LaSalle Street Chicago, Illinois 60605

Re: CBOEdirect Screen Based Trading System

Dear Mr. Evangelou:

In your letter dated March 28, 2003, you request interpretive guidance regarding the application of Rule 11a2-2(T) under the Securities Exchange Act of 1934 ("Exchange Act") to transactions executed via the Chicago Board Options Exchange's ("CBOE") CBOEdirect Screen Based Trading System ("CBOEdirect").

Section 11(a) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on that exchange for its own account, the account of an associated person, or an account over which it or its associated person exercises investment discretion (collectively, "covered accounts") unless an exception applies. Rule 11a2-2(T) provides exchange members with an exemption, in addition to the exceptions delineated in the statute. Known as the "effect versus execute" rule, Rule 11a2-2(T) permits an exchange member, subject to certain conditions, to effect transactions for covered accounts by arranging for an unaffiliated member to execute the transactions directly on the exchange floor. To comply with the rule's conditions, a member (1) must transmit the order from off the exchange floor, (2) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution, 1 (3) may not be affiliated with the executing member, and (4) with respect to an account over which the member or an associated person has investment discretion, neither the member nor its associated person may retain any compensation in connection with effecting the transaction without express written consent from the person authorized to transact business for the account in accordance with the rule.

Off-Floor Transmission

The requirement in Rule 11a2-2(T) for orders to be transmitted from off the exchange floor reflects Congress' intent that Section 11(a) should operate to put member money managers and non-member money managers on the same footing for purposes of their transactions for covered accounts. In considering other automated systems, the Commission and the staff have stated that the off-floor transmission requirement would be met if a covered account order is transmitted from off the floor directly to the exchange floor by electronic means. 2 Because all orders sent to CBOEdirect will be electronically submitted directly to the system from remote terminals, the staff believes that orders transmitted for execution on CBOEdirect satisfy the off-floor transmission requirement.

Non-Participation in Order Execution and Execution Through Unaffiliated Member

Rule 11a2-2(T) further provides that the exchange member and its associated persons may not participate in the execution of a transaction once the order has been transmitted to the exchange floor. This requirement was included to prevent members with their own brokers on the exchange floor from using those persons to influence or guide their orders' execution. This requirement does not preclude members from canceling or modifying orders, or from modifying the instructions for executing orders, after they have been transmitted to the floor. Such cancellations or modifications, however, also must be transmitted from off the exchange floor. 3

In a release discussing both the COMEX and the PACE systems, the Commission noted that a member relinquishes any ability to influence or guide the execution of its order at the time the order is transmitted into the systems and, although the execution is automatic, the design of these systems insures that members do not posses any special or unique trading advantages in handling orders after transmission to the trading floor. 4 Similarly, orders submitted to CBOEdirect will enter an order processing queue and be executed against the account of one of the market makers who is logged on the CBOEdirect system or an order resident in the system based on an established matching algorithm. To the extent that users of CBOEdirect will relinquish control of their orders upon transmission to CBOEdirect, and will not be able to influence or guide the execution of their orders, the staff believes that this requirement is met with respect to orders that are executed automatically on CBOEdirect.

Furthermore, although Rule 11a2-2(T) contemplates having an order executed by an exchange member who is unaffiliated with the member initiating the order, the Commission has recognized that this requirement is not applicable when automated exchange facilities are used. For example, in considering the operation of COMEX and PACE, the Commission noted that while there is no independent executing exchange member, the execution of an order is automatic once it has been transmitted into the systems. Because the design of these systems ensures that members do not possess any special or unique trading advantages in handling their orders after transmitting them to the exchange floors, the Commission has stated that executions obtained through these systems satisfy the independent execution requirement of Rule 11a2-2(T). 5 Similarly, to the extent that the design of CBOEdirect ensures that members do not possess any special or unique trading advantages in the handling of their orders after transmission, a member effecting a transaction through CBOEdirect satisfies the requirement for execution through an unaffiliated member.

However, the priority rule for CBOEdirect, CBOE Rule 43.1, allows certain members of CBOE's screen based trading committee (the "Committee") to determine which priority provisions of Rule 43.1 will govern options trading on CBOEdirect. To the extent a member firm sought to manipulate CBOEdirect's trading algorithm by causing a Committee member to change the algorithm in order to benefit the firm, its client, or a related entity in the execution of a pending order, neither the requirement for non-participation in order execution not the requirement for execution through an unaffiliated member will be satisfied. To the extent CBOE's surveillance of the matching algorithm ensures that members do not abuse Rule 43.1 in a manner that is inconsistent with Section 11(a) of the Exchange Act, the staff believes that both the requirement for non-participation in order execution and the requirement for execution through an unaffiliated member will be satisfied.

Non-Retention of Compensation for Discretionary Accounts

The staff notes that members who intend to rely on Rule 11a2-2(T) in connection with transactions using CBOEdirect must comply with the requirements of Section (a)(2)(iv) of the rule.

Conclusion

This interpretive position is based solely on your representations and the facts presented, and is strictly limited to the application of Rule 11a2-2(T) to the CBOEdirect transactions described above. Any different facts or circumstances may require a different response.

Sincerely,

Paula R. Jenson Deputy Chief Counsel

Footnotes

The member may, however, participate in clearing and settling the transaction.

See, e.g. , Securities Exchange Act Release No. 29237 (May 31, 1991) (regarding NYSE's Off-Hours Trading Facility); Securities Exchange Act Release No. 15533 (January 29, 1979) (regarding the Amex Post Execution Reporting System, the Amex Switching System, the Intermarket Trading System, the Multiple Dealer Trading Facility of the Cincinnati Stock Exchange, the PCX's Communications and Execution System, and the Phlx's Automated Communications and Execution System); Securities Exchange Act Release No. 14563 (March 14, 1978) (regarding the NYSE's Designated Order Turnaround System). See also Letter from Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, SEC, to Edith Hallahan, Associate General Counsel, Phlx (March 24, 1999) (regarding Phlx's VWAP Trading System); Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to David E. Rosedahl, PCX (November 30, 1998) (regarding OptiMark); Letter from Brandon Becker, Director, Division of Market Regulation, SEC, to George T. Simon, Foley & Lardner (November 30, 1994) (regarding Chicago Match).

Securities Exchange Act Release No. 14563 (March 14, 1978).

Securities Exchange Act Release No. 15533 (January 29, 1979) at n. 25.

Securities Exchange Act Release No. 15533 (January 29, 1979) at n. 25.

Incoming Letter

March 28, 2003

Ms. Catherine McGuire Chief Counsel Division of Market Regulation Securities and Exchange Commission 450 Fifth Street, N.W. Washington DC 20549

Re: Proposal to Adopt a Screen Based Trading System - File No. SR-CBOE-00-55

Dear Ms. McGuire:

In connection with the above referenced filing, the Chicago Board Options Exchange, Incorporated ("CBOE" or "Exchange") respectfully requests the Division of Market Regulation of the Securities and Exchange Commission ("SEC" or "Commission") to provide interpretive guidance regarding the application of Rule 11a2-2(T) 1 to CBOE's proposed rule change SR-CBOE-00-55, which proposes to adopt a screen based trading system known as CBOE direct ®. 2 CBOE believes its proposed rule change meets the requirements of Rule 11a2-2(T). 3 The Exchange believes the policy concerns Congress sought to address in Section 11(a) of the Act, 4 the time and place advantage members on exchange floors have over non-members off the floor and the general public, are not present in the CBOE direct system.

I. Background

CBOE has analyzed the Application of Section 11(a) of the Act and Rule 11a2-2(T) thereunder relative to option orders that are executed through CBOE direct. For the reasons discussed below, CBOE believes the proposed rule change in SR-CBOE-00-55 is consistent with the stated objectives of Section 11(a) of the Act.

II. Discussion

Effect Versus Execute Rule

Section 11(a) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on that exchange for his own account, the account of an associated person, or an account over which he or his associated person exercises investment discretion (collectively, "covered accounts") unless an exception applies. Rule 11a2-2(T) provides exchange members with an exemption, in addition to the exceptions delineated in the statute. Known as the "effect versus execute" rule, Rule 11a2-2(T) permits an exchange member, subject to certain conditions, to effect transactions for covered accounts by arranging for an unaffiliated member to execute the transactions directly on the exchange floor. To comply with the rule's conditions, a member (1) must transmit the order from off the exchange floor, (2) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution, 5 (3) may not be affiliated with the executing member, and (4) with respect to an account over which the member has investment discretion, neither the member nor his associated person may retain any compensation in connection with effecting the transaction without express written consent from the person authorized to transact business for the account in accordance with the rule.

The requirements of the "effect versus execute" rule are "designed to put members and non-members on the same footing, to the extent practicable, in light of the purposes of Section 11(a)." 6 For the reasons set forth below, CBOE believes the structural and operational characteristics of CBOE direct places all users, both members and non-members, on the "same footing", as intended by Rule 11a2-2(T).

Off-Floor Transmission . Rule 11a2-2(T) requires the orders for a covered account transaction to be transmitted from off the exchange floor. The Commission considered this requirement in the context of several automated trading and electronic order-handling facilities operated by various national securities exchanges. 7

The Commission determined that a covered account order sent through such an exchange facility would be deemed to be transmitted from off the floor. Like these other automated systems, orders sent to CBOE direct will be transmitted from remote terminals directly to the system by electronic means. Therefore, users' orders electronically received by CBOE direct satisfy the off-floor transmission requirement for the purposes of the "effect versus execute" rule. 8

Non-Participation in Order Execution . The "effect versus execute" rule provides the exchange member and his associated person may not participate in the execution of the transaction once the order has been transmitted. This requirement originally was intended to prevent members from using their own brokers on the exchange floor to influence or guide the execution of their orders. 9 It does not preclude members from canceling or modifying orders, or from modifying instructions for executing orders, after they have been transmitted; provided, however, such cancellations or modifications are transmitted from off the exchange floor. 10 In analyzing the application of the non-participation requirement to automated exchange facilities, the Commission specifically noted in regard to the COMEX and PACE systems (1) the "initiating member relinquishes any ability to influence or guide the execution of its order at the time the order is transmitted in the system" and (2) "[while] the execution of the order is thereafter automatic and does not involve any independent executing member, the design of those systems insures members do not possess any special or unique trading advantages in handling their orders after transmission to the COMEX and PACE systems." The systems were deemed to comply with this requirement. More recently, the Commission reached the same conclusion concerning the VWAP Trading System, ArcaEx, OptiMark and the Chicago Match, stating that a member does not retain the ability to influence or guide the execution of an order after the member submits the order to each of these systems. 11 As with these trading systems, eligible orders submitted to CBOE direct will similarly meet the non-participation requirement. Upon submission to CBOE direct , an inbound order will enter an order processing queue and be executed against the account of one of the market makers who is logged on the CBOE direct system or an order resident in the system based on an established matching algorithm. The subsequent execution does not depend upon the person who entered the order. Therefore, at no time following the submission of an order will a broker-dealer who enters an order retain any ability to control the timing of an execution or otherwise enjoy special order-handling advantages inherent on an exchange floor. Accordingly, CBOE believes the non-participation requirement is met whenever inbound orders are executed automatically on CBOE direct .

Execution Through Unaffiliated Member . Although Rule 11a2-2(T) contemplates having an order executed by an exchange member, unaffiliated with the member initiating the order, the Commission has recognized the requirement is not applicable where automated exchange facilities are used. For example, in considering the operation of COMEX and PACE, among other systems, the Commission noted, while there is no independent executing exchange member, the execution of an order is automatic once it has been transmitted to the system. 12

Because the design of these systems ensures members do not possess any special or unique trading advantages in handling their orders after transmitting them to the exchange floor, the Commission has stated executions obtained through these systems satisfy the independent execution requirement of Rule 11a2-2(T). 13 This principle is directly applicable to CBOE direct ; the design of CBOE direct ensures broker-dealers do not have any special or unique trading advantages in handling their orders after transmission. Accordingly, a broker-dealer effecting a transaction through CBOE direct satisfies the requirement for execution through an unaffiliated member.

Non-Retention of Compensation for Discretionary Accounts . Finally, the exemption in Rule 11a2-2(T) states, in the case of a transaction effected for an account for which the initiating member exercises investment discretion, in general, the member may not retain compensation for effecting the transaction. As a prerequisite for usage of the CBOE direct system, if a member is to rely on Rule 11a2-2(T) for a managed account transaction, the member must comply with the limitations on compensation as set forth in paragraph (a)(2)(iv) of the "effect versus execute" rule.

CBOE direct 's Matching Algorithm/Priority Rules

The Exchange notes that the priority rule for CBOE direct (Rule 43.1) cannot be utilized by Exchange members in a manner that is inconsistent with the objectives of Section 11(a). While Rule 43.1 allows the appropriate SBT Trading Committee to determine which priority provisions of Rule 43.1 will govern options trading on CBOE direct , the Exchange does not intend to modify the application of the priority rules on an intra-day basis. First, CBOE trading committees commonly consist of twenty or more members who conduct business on different parts of the trading floor (sometimes off of the trading floor) and it would be extremely impracticable to convene a meeting during business hours for any purpose, let alone to effect a change to CBOE's priority algorithms. Also, the Exchange will issue circulars in connection with any change to how the priority rules are applied, and such circulars will be issued in advance of the actual implementation of the change thereby providing members and non-members with notice.

The Exchange would also like to emphasize that existing CBOE rules safeguard against members abusing Rule 43.1 to circumvent Section 11(a). For example, Rule 4.18 is designed to prevent the misuse of material non-public information. Thus, to the extent a member firm sought to manipulate CBOE's trading algorithm by directing an affiliated person on CBOE's SBT Trading Committee to request a committee meeting to change the algorithm in order to benefit the firm, its client, or a related entity in the execution of a pending order, the Exchange believes the disclosure of the pending order(s) and/or imminent transaction(s) to the affiliated person would be deemed a violation of Rule 4.18. Additionally, the Exchange believes any effort generally to manipulate the trading algorithm to facilitate a favorable execution for a pending order would be deemed a violation of CBOE Rule 4.1 (Just and Equitable Principles of Trade). Lastly, while these rules should prevent any abuses of Rule 43.1, CBOE will provide for surveillance of the manner in which the matching algorithm is modified (to the extent it is ever modified) to ensure that members do not abuse Rule 43.1 in a manner that is inconsistent with Section 11(a).

III. Conclusion

The Exchange believes its CBOE direct system, coupled with the rules described above and appropriate surveillance, satisfies the four requirements of the "effect versus execute" rule as well as the general policy objectives of Section 11(a) of the Act. The proposed rule change to adopt a screen-based options trading platform is beneficial because it will facilitate transactions in securities and will remove impediments to and perfect the mechanism of a free and open market. The proposed rule change will place all CBOE direct users, members and non-members, on the "same footing," as intended by Rule 11a2-2(T). In light of the aforementioned, CBOE believes, under its proposal, no member will be able to engage in proprietary trading in a manner inconsistent with Section 11(a) of the Act.

Sincerely,

Angelo Evangelou

cc: Joanne Moffic-Silver

Footnotes

17 C.F.R. 240.11a2-2(T).

Please note that this letter replaces CBOE's virtually identical letter of October 10, 2002.

17 C.F.R. 240.11a2-2(T). Rule 11a2-2(T) is one of the exceptions to Section 11(a) of the Securities and Exchange Act ("Act") prohibition on proprietary trading.

15 U.S.C. 78k(a).

The member may, however, participate in clearing and settling the transaction.

Securities Exchange Act Release No. 14713, (April 27, 1978); 43 FR 18557, 18560.

Among the systems considered by the Commission are (1) the Phlx's VWAP Trading System ( see VWAP Letter); (2) the PCX Application of OptiMark ( see OptiMark Letter); (3) Chicago Match ( see Chicago Match Letter); (4) the Amex's Post Execution Reporting System and the Amex Switching System ( see 1979 Release at n. 25); (5) ITS; (6) the Multiple Dealer Trading Facility of the CSE; (7) the PCX's Communications and Execution System ("COMEX"); and (8) the Phlx's Automated Communications and Execution System ("PACE") ( see 1979 Release at nn. 19-35 and accompanying text).

The Commission has not considered the lack of a traditional physical floor to be an impediment to the satisfaction of the off-floor requirement. See, e.g. , 1979 Release (discussing the CSE's NSTS satisfaction of this requirement).

See , Securities Exchange Act Release No. 14563 (March 14, 1978), 43 FR 11542 (March 17, 1978).

Id.

See , Letter from Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, SEC, to Edith Hallahan, Associate General Counsel, Phlx, dated March 24, 1999 ("VWAP Letter")(approving Phlx's VWAP Trading System); Letter from Paula Jenson, Deputy Chief Counsel, Division of Market Regulation, SEC to Kathryn Beck, PCX, dated October 25, 2001 ("ArcaEx") (approving ArcaEx); Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC to David E. Rosedahl, PCX, dated November 30, 1998 ("OptiMark Letter") (approving the PCX Application of OptiMark); and Letter regarding Chicago Match, from Brandon Becker, Director, Division of Market Regulation, SEC to George T. Simon, Partner, Foley & Lardner, dated November 30, 1994 ("Chicago Match Letter").

See , 1979 Release. Also see, VWAP Letter, OptiMark Letter and Chicago Match Letter.

Id.

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Modified: 02/09/2005