Transactions in Listed Options Under Exchange Act Rule 11Ac1-1

Action: Publication of Division of Market Regulation Staff Legal Bulletin

Date: January 20, 2004

Summary: This staff legal bulletin sets forth the views of the Division of Market Regulation concerning the application of Rule 11Ac1-1 under the Securities Exchange Act of 1934 to transactions in listed options.

Supplementary Information: The statements in this legal bulletin represent the views of the staff of the Division of Market Regulation. This legal bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission ("Commission"). Further, the Commission has neither approved nor disapproved its content.

Contact Person: For further information, please contact John C. Roeser, Special Counsel, at (202) 942-0762, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington D.C. 20549-1001.

I. Introduction

In November 2000, the Commission adopted amendments to Exchange Act Rule 11Ac1-1 ("Quote Rule")¹ to extend the application of the Quote Rule to options exchanges and options market makers, effective April 1, 2001.

Generally, the Quote Rule requires every options exchange to establish procedures for collecting the bids, offers, and the sizes of those bids and offers communicated by an exchange member as principal or agent, to another member. In addition, the Quote Rule requires each member to promptly communicate its best bids, offers, and sizes to its exchange in accordance with those procedures. These members are referred to as responsible broker-dealers under the Quote Rule with respect to the bids, offers, and sizes they communicate, as principal or agent, to other members on the exchange. The exchange is required to make available to quotation vendors the best bid and offer and the aggregate sizes of the best bid and offer.

The Quote Rule also requires each member to execute orders presented to it, including orders received through the options intermarket linkage, at a price at least as favorable as its best bid or offer in any amount up to the size of that bid or offer, subject to certain exceptions.

The following illustrations are consistent with the advice Division staff has provided and do not change the rule or provide new interpretations of the rule. The Division believes that the Quote Rule is clear and is issuing this staff legal bulletin solely to illustrate the application of the rule to options market makers in specific scenarios. The illustrations do not necessarily contain a discussion of all the material considerations necessary to reach the conclusions stated. These illustrations are intended to provide general guidance, but the facts and circumstances relating to particular broker-dealers or exchanges may differ, and the staff notes that even slight variations may require different responses.

In addition, these illustrations are premised on several important assumptions. First, the discussions assume close familiarity with the text of the Quote Rule and the Adopting Release, and we urge you to read carefully the Quote Rule and the Adopting Release. The responses are a complement to, and not a substitute for, these sources. Second, the terms used in this staff legal bulletin have the meanings set forth in the definitions of paragraph (a) of the Quote Rule.

The Division may update these illustrations periodically by issuing an updated staff legal bulletin. In each updated staff legal bulletin, the questions and answers with modified or new material since the last update will be marked as "modified" or "new."

The illustrations addressed in this bulletin are as follows:

II. Illustrations

Scenario 1: Obligation to Multiple Orders in the Same Series

A market maker quoting in an options series for 250 contracts is presented an order to buy 50 contracts in that series. Before it executes the first order, the market maker receives a second order to buy 50 contracts in the same series as the first order. After executing the first order, may the market maker revise its quote and execute the second order at the revised quote?

Response 1:

The market maker must execute the first order for 50 contracts at its quote. If the market maker is in the process of effecting a transaction, the Quote Rule permits the market maker to revise its quote immediately after completion of such transaction before executing another trade in the same series. A market maker is considered to be in the process of effecting a transaction from the moment an order is presented to him for execution until the completion of communication of all information necessary to complete the transaction.² Thus, after the execution of the first order for 50 contracts, the market maker may revise its quotation immediately, and, if an execution at this price is otherwise permissible, the market maker may execute the second order at its revised quotation.

Scenario 2: Obligation by Series

A market maker who is quoting in May 30, June 30, and other series of calls in XYZ receives an order to buy 50 contracts of May 30 Calls in XYZ. While in the process of executing that order, the market maker receives an order to buy 50 contracts of June 30 Calls in XYZ. Is the market maker relieved of its obligations under the Quote Rule to be firm for its quote for the order for June 30 Calls?

Response 2:

No. Each series is a separate security. The Quote Rule requires a market maker to be firm for its quote in each series, regardless of whether it is in the process of effecting a transaction in a separate option series within the same class. The market maker must fill each order for 50 contracts at its quote at the time each order is presented.

Scenario 3: When an Order is "Presented"

Single, Collective Trading Crowd Quote

Many of today's floor-based options exchanges have rules that establish that the trading crowd for a particular option is responsible under the Quote Rule for the exchange's disseminated quote. These rules are a response to technology limitations that do not permit each market maker in the crowd to quote independently. When must the quote be firm when the trading crowd is the responsible broker-dealer?

Response:

Unless an exception applies, the Quote Rule requires a responsible broker-dealer to execute an order at its quote when that order is presented. When an exchange's rules establish the trading crowd as the responsible broker-dealer with respect to the exchange's disseminated quote, an order is considered presented when any one member of the trading crowd is presented with the order. Thus, for example, if orders sent to the exchange are routed to an electronic device managed by the specialist, such orders are presented to the trading crowd when received by the specialist on such device. In addition, orders represented by a floor broker are presented to the trading crowd when the floor broker communicates such orders to the trading crowd.

Individual Market Maker Quotes, with Incoming Orders Routed to Electronic Device Operated by Specialist

As exchange systems change to permit each market maker in a crowd to generate its own quote, each individual market maker will be the responsible broker-dealer with respect to its own quote. If orders continue to be routed to an electronic device managed by the specialist, when are such orders presented to a responsible broker-dealer?

Response:

Unless an exception applies, the Quote Rule requires a responsible broker-dealer to execute an order at its quote when that order is presented. When each market maker is the responsible broker-dealer with respect to its own quote, but orders are routed to an electronic device managed by the specialist, such orders are presented: (1) to the specialist when it is the responsible broker-dealer when received on such device; and (2) to any other responsible broker-dealer in the trading crowd when the specialist announces the order to the crowd. An order represented by a floor broker is presented to a responsible broker-dealer in the trading crowd when the floor broker communicates such order to that responsible broker-dealer.

Individual Market Maker Quotes with Incoming Orders Routed to Market Maker at the Best Price

If an individual market maker generates its own quotations and is, therefore, the responsible broker-dealer with respect to its quote, and exchange systems route incoming orders to the responsible broker-dealer with priority, when is an order presented to a responsible broker-dealer?

Response:

Unless an exception applies, the Quote Rule requires a responsible broker-dealer to execute an order at its quote when that order is presented. When each market maker is the responsible broker-dealer with respect to its own quote, an order is presented to it when received by the market maker from the exchange system.

Scenario 4: Quotation Revisions Renew Obligation

A market maker is quoting in a series at 1.00 — 1.20, 50 x 50. The market maker is presented with an order to buy 50 contracts. The market maker changes its quote to .95 — 1.15, 50 x 50. The market maker is presented with a second order to buy 50 contracts. The market maker changes its quote to 1.10 — 1.25, 50 x 50. At what price must the market maker execute the first and second orders?

Response 4:

The market maker must execute the first order at 1.20, which was its quote at the time the order was presented. The Quote Rule requires a responsible broker-dealer to be firm for each quote it disseminates. Accordingly, when its quote changed to .95-1.15, 50 x 50, the responsible broker-dealer's obligations were renewed. Thus, the responsible broker-dealer would be obligated to execute the second order at its revised offer of 1.15.

Scenario 5: Orders Presented Just Prior to Close

While a market maker is quoting in a series, an order is presented to buy. Then trading is closed. Must the market maker execute the order that is presented just prior to the close of trading?

Response 5:

Yes. Under the Quote Rule, a responsible broker-dealer is obligated to execute orders presented to it. There is no exception to this obligation for orders that are presented just prior to the end of trading. Orders submitted after the close, however, need not be executed. In the scenario above, the order would be entitled to an execution at the market maker's quote.

Scenario 6: Cancelled Orders on the Book

A responsible-broker-dealer's quote reflects a customer limit order. The limit order is cancelled, but the responsible broker-dealer does not change its quote to reflect the cancellation. An order is presented to the responsible broker-dealer. For what price and size must the responsible broker-dealer be firm for the incoming order?

Response 6:

Under the Quote Rule, the responsible broker-dealer must be firm for customer limit orders that establish the best bid or offer on an exchange. Thus, cancellation of the booked order does not relieve the responsible broker-dealer of its obligation to honor its quotation that reflects this limit order.

Scenario 7: Obligation for an Order Presented on the Other Side of the Market

A market maker is quoting at 1.00 — 1.20, 250 x 500. The market maker is presented an order to buy 500 contracts. While the market maker is in the process of executing the first order, the market maker is presented an order to sell 250 contracts. The market maker executes the order to buy 500 contracts at 1.20 and immediately revises its quote to .95 — 1.25, 250 x 500

At what price must the market maker execute the order to sell 250 contracts?

Response 7:

Because the market maker revised its quotation immediately after executing the first order, it could execute the second order at .95 (i.e., the market maker's revised bid), assuming an execution by the market maker at this price is otherwise permissible.

Endnotes

¹ 17 CFR 240.11Ac1-1; See Securities Exchange Act Release No. 43591 (November 17, 2000), 65 FR 75439 (December 1, 2000) ("Adopting Release").

² See Securities Exchange Act Release No. 14415 (January 26, 1978), 43 FR 4342 (February 1, 1978) at note 33.