Self-Regulatory Organizations; Chicago Stock Exchange, Inc.; Notice of Filing of Proposed Rule Change To Adopt Standards for the Cancellation or Adjustment of Bona Fide Error Trades, the Submission of Error Correction Transactions, and the Cancellation or Adjustment of Stock Leg Trades of Stock-Option or Stock-Future Orders
Federal Register, Volume 78 Issue 181 (Wednesday, September 18, 2013)
Federal Register Volume 78, Number 181 (Wednesday, September 18, 2013)
Notices
Pages 57431-57444
From the Federal Register Online via the Government Printing Office www.gpo.gov
FR Doc No: 2013-22648
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SECURITIES AND EXCHANGE COMMISSION
Release No. 34-70381; File No. SR-CHX-2013-16
Self-Regulatory Organizations; Chicago Stock Exchange, Inc.; Notice of Filing of Proposed Rule Change To Adopt Standards for the Cancellation or Adjustment of Bona Fide Error Trades, the Submission of Error Correction Transactions, and the Cancellation or Adjustment of Stock Leg Trades of Stock-Option or Stock-Future Orders
September 12, 2013.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\, and Rule 19b-4 \2\ thereunder, notice is hereby given that on September 4, 2013 the Chicago Stock Exchange, Inc. (``CHX'' or the ``Exchange'') filed with the Securities and Exchange Commission (``Commission'' or ``SEC'') the proposed rule change as described in Items I, II and III below, which Items have been prepared by the Exchange. CHX has filed this proposal pursuant to Section 19(b)(2) of the Act.\3\ 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.
\3\ 15 U.S.C. 78s(b)(2).
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Self-Regulatory Organization's Statement of the Terms of the Substance of the Proposed Rule Change
CHX proposes to amend Article 20, Rule 9 to outline and clarify the Exchange's current requirements for the cancellation of trades based on Bona Fide Error and to establish new requirements for the adjustment of trades based on Bona Fide Error; to adopt Article 20, Rule 9A to detail the Exchange's current requirements for Error Correction Transactions; and to
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adopt Article 20, Rule 11 to amend the Exchange's current requirements for the cancellation of the stock leg trade of a Stock-Option order, to establish new requirements for the adjustment of the stock leg trade of a Stock-Option order, and to allow the stock leg trade of Stock-Future orders to be cancelled or adjusted pursuant to proposed Rule 11.
The text of this proposed rule change is available on the Exchange's Web site at (www.chx.com) and in the Commission's Public Reference Room.
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Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the CHX included statements concerning the purpose of and basis for the proposed rule changes and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. The CHX has prepared summaries, set forth in sections A, B and C below, of the most significant aspects of such statements.
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Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
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Purpose
The Exchange proposes to amend Article 20, Rule 9 to outline and clarify the Exchange's current requirements for the cancellation of trades based on Bona Fide Error and to establish new requirements for the adjustment of trades based on Bona Fide Error; to adopt Article 20, Rule 9A to detail the Exchange's current requirements for Error Correction Transactions; and to adopt Article 20, Rule 11 to amend the Exchange's current requirements for the cancellation of the stock leg trade of a Stock-Option order, to establish new requirements for the adjustment of the stock leg trade of a Stock-Option order, and to allow the stock leg trade of Stock-Future orders to be cancelled or adjusted pursuant to proposed Rule 11.
Proposed Article 20, Rule 9 ``Cancellation or Adjustment of Bona Fide Error Trades''
Current Article 20, Rule 9 outlines two bases for the cancellation of trades at the request of all parties to the trade. Specifically, current Article 20, Rule 9(a) provides that transactions made in ``demonstrable error'' \4\ and cancelled by both parties may be unwound, subject to the approval of the Exchange. Although the Exchange has provided specific guidance to its Participants in the form of CHX Information Memorandums with respect to demonstrable error, the CHX rules are silent as to the specific requirements or processes involved in the demonstrable error trade cancellation process.\5\ In sum, the Exchange currently requires ``concrete, documented evidence that the initial trade was transacted in error or includes an erroneous term that requires the cancellation of the initial report.'' \6\
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\4\ Although not currently in the CHX rules, the Exchange defines ``demonstrable error'' as a ``Bona Fide Error'' exactly as defined under the ``Order Exempting Certain Error Correction Transactions From Rule 611 of Regulation NMS Under the Securities Exchange Act of 1934.'' See Securities Exchange Act Release No. 55884 (June 8, 2007), 72 FR 32926 (June 14, 2007). As discussed below, the Exchange proposes to adopt this definition as proposed Article 1, Rule 1(hh).
\5\ Among other things, these CHX Information Memorandums have provided evidentiary standards and parameters for trade cancellations based on demonstrable errors.
For instance, CHX Information Memorandum (MR-11-8) states the following, in pertinent part (italics added):
Cancellation of Transactions (CHX Article 20, Rule 9)
``Additionally, the Department wishes to highlight the CHX rule requirement that trades can only be cancelled or busted based on mutual agreement of all parties involved if the initial trade was done in demonstrable error. The same factors used in making a Bona Fide Error determination apply with equal force to proposed cancellations under Article 20, Rule 9. Proper documentary proof will be required at the time of such requests in this case as well. While we cannot say in advance what may be considered adequate proof of demonstrable error, the basic standard will be concrete, documented evidence that the initial trade was transacted in error or includes an erroneous term that requires the cancellation of the initial report. Examples might include transcribed evidence of the correct trade terms versus what was entered in error (i.e., a price of $15.42 vs $51.42) or recorded evidence of a misconveyance of terms (i.e., print stock ABC vs BAC). Requests will be reviewed on a case-by-case basis prior to being transacted by CHX Operations staff.
Finally, we note that trades may only be cancelled pursuant to CHX Article 20, Rule 9. The Exchange does not have the authority to modify or adjust the individual terms of previously reported transactions.''
\6\ Id.
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Moreover, current Article 20, Rule 9(b) outlines rules for the cancellation of the stock leg trade of a Stock-Option order. Specifically, current Article 20, Rule 9(b) provides that a trade representing the stock leg of a stock-option order may be cancelled at the request of all parties to the trade if, inter alia, market conditions in any of the non-Exchange markets prevent the options leg from executing at the price agreed upon by the parties or the options leg was cancelled by the exchange on which it was executed.
Although, both current Article 20, Rule 9(a) and Rule 9(b) require all the parties to the trade to consent to the cancellation of the trade, the reasons for each cancellation are substantively different. Given this difference, the Exchange proposes to separate current Article 20, Rule 9 into two different rules. The Exchange proposes to detail, inter alia, the requirements for the cancellation of trades based on demonstrable error under proposed Rule 9 and to detail, inter alia, the requirements for the cancellation of the stock leg of a stock-option order under proposed Rule 11.\7\
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\7\ As discussed in great detail below, the Exchange proposes to clarify and expand the scope of current Article 20, Rules 9(a) and 9(b).
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In sum, proposed Rule 9 (``Cancellation or Adjustment of Bona Fide Error Trades'') retains the substance of current Article 20, Rule 9(a), with some amendments. Under proposed Rule 9, the Exchange proposes (1) to explicitly outline and expand the current requirements for cancellations of trades based on Bona Fide Error \8\ and (2) to allow for adjustments of trades based on Bona Fide Error, provided that certain additional requirements are met.\9\
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\8\ See supra note 4.
\9\ The Exchange notes that proposed Article 20, Rule 9 does not extinguish Participants' market access obligations pursuant to Rule 15c3-5 under the Act. See 17 CFR 240.15c3-5.
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Specifically, proposed Rule 9(a) states that a trade executed on the Exchange in ``Bona Fide Error,'' as defined under proposed Article 1, Rule 1(hh), may be cancelled or adjusted pursuant to this Rule, subject to the approval of the Exchange. The Exchange notes that proposed Rule 9 only applies to Bona Fide Error trades that were executed on the Exchange and, as such, orders that are routed to other market centers and executed at such away market centers are not within the purview of proposed Rule 9.\10\ Moreover, the Exchange proposes to define ``Bona Fide Error'' exactly as defined in the Commission's release granting exemptive relief for Error Correction Transactions.\11\ Thus, proposed Article 1, Rule 1(hh) defines ``Bona Fide Error'' as:
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\10\ Although the Exchange anticipates implementing it in the near future, the Exchange does not currently offer order routing.
\11\ See supra note 4.
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(1) the inaccurate conveyance or execution of any term of an order, including, but not limited to, price, number of shares or other unit of trading; identification of the security; identification of the account for which securities are purchased or sold; lost or otherwise misplaced order tickets; or the execution of an order on the wrong side of a market;
(2) the unauthorized or unintended purchase, sale, or allocation of
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securities, or the failure to follow specific client instructions;
(3) the incorrect entry of data into relevant systems, including reliance on incorrect cash positions, withdrawals, or securities positions reflected in an account; or
(4) a delay, outage, or failure of a communication system used to transmit market data prices or to facilitate the delivery or execution of an order.
The Exchange notes that it currently permits trade cancellations based on Bona Fide Errors of the Participant submitting the order to the Matching System (``executing broker Participant'') or of the customer of the executing broker Participant, so long as the Bona Fide Error can be reasonably identified and supported by the executing broker Participant and verified by the Exchange. Thus, the Exchange proposes to clarify this limitation as proposed paragraph .01 of the Interpretations and Policies of proposed Rule 9. Specifically, proposed paragraph .01 provides that proposed Rule 9 shall only apply to Bona Fide Errors committed by the Participant that submitted the order to the Matching System or the customer of the Participant that submitted the order to the Matching System.
Proposed Rule 9(b) outlines the specific requirements that must be met by the executing broker Participant before the Exchange can consider a request to cancel or adjust an erroneous trade.\12\ Specifically, proposed paragraph (b) states that the Exchange may approve a request for a trade cancellation or adjustment pursuant to this Rule and take the corrective action(s) necessary to effectuate such a cancellation or adjustment, provided that the items listed thereunder are submitted to the Exchange, in a form prescribed by the Exchange,\13\ by the Participant that submitted the erroneous trade. Moreover, the proposed paragraph continues by stating that all of the requirements of the proposed paragraph must be complied with, to the satisfaction of the Exchange, before a trade cancellation or adjustment pursuant to this proposed Rule may be approved or any corrective action may be taken. In addition, the Exchange shall have sole discretion in determining whether the requirements of this Rule have been satisfied. Thereunder, the specific requirements are listed as proposed paragraphs (b)(1)-(3), which states as follows:
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\12\ Although the Exchange currently requires, inter alia, documentary proof of a Bona Fide Error prior to the Exchange considering a trade cancellation, there are no such requirements stated in the current CHX rules. See supra note 5.
\13\ Prior to proposed Rule 9, Rule 9A, and Rule 11 becoming operative, the Exchange will provide all Participants with specific instructions, through a CHX Information Memo or the like, which will detail the ``form prescribed by the Exchange'' contemplated by proposed paragraph (b).
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(1) Timely written request. The Participant that submitted the erroneous trade shall submit a written request for cancellation or adjustment, including all information and supporting documentation required by this Rule, including a Trade Error Report, no later than 4:30 p.m. CST on T+1. The Exchange will retain a copy of the written request, information and supporting documentation. In extraordinary circumstances, a cancellation or adjustment may be requested and effected after T+1, with the approval of an officer of the Exchange;
(2) Bona Fide Error. The Participant that submitted the erroneous trade shall identify the error that is a ``Bona Fide Error,'' as defined under Article 1, Rule 1(hh), and the source of the Bona Fide Error. The Participant shall also provide supporting documentation showing the objective facts and circumstances concerning the Bona Fide Error, such as the original terms of the order or a record of the misconveyance of terms; and
(3) All parties consent. The Exchange shall verify that the cancellation or adjustment is requested by all parties involved in the Bona Fide Error trade (or by an authorized agent of those parties). The Participant that submitted the erroneous trade shall provide supporting documentation evidencing this consent.
With respect to proposed paragraph (b)(1), although not currently stated in the CHX rules, the T+1 time requirement is the current time limit required by the Exchange for cancellation of trades based on demonstrable error. Based on its experience, the Exchange submits that the T+1 time requirement (i.e., day of erroneous trade + one full trading day) is reasonable. The flexibility of the T+1 requirement is particularly necessary where the Bona Fide Error was not committed by the executing broker Participant, but by the customer of the executing broker Participant that relayed inaccurate order terms to the executing broker Participant. In such a case, the executing broker Participant would not have known, at the time the erroneous trade was executed, that the terms of the trade were erroneous. Thus, there would inevitably be some delay before the Bona Fide Error was discovered and the source of the error identified. Moreover, certain Bona Fide Errors may not be discovered until clearing submissions have been made. In such an instance, the T+1 requirement would be essential for Bona Fide Errors to surface. Furthermore, in recognizing that extraordinary circumstances may prevent compliance with the T+1 requirement, the Exchange submits that requiring approval of an officer of the Exchange to waive the T+1 requirement will allow the Exchange to verify that such extraordinary circumstances exist on a case-by-case basis and will consequently safeguard against the abuse of this exception.\14\
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\14\ The Exchange anticipates that the list of eligible officers would include the Chief Operating Officer, Chief Regulatory Officer, General Counsel, and Vice President of Market Regulation.
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With respect to proposed paragraph (b)(2), the Exchange notes that the supporting documentation showing the objective facts and circumstances concerning the Bona Fide Error may differ, depending on the source and nature of the Bona Fide Error. Although it is difficult, if not impossible, to establish a general rule as to what would constitute sufficient documentation,\15\ copies of verifiable communications (e.g., email, instant message, recorded phone lines, internal order ticket) will usually be required by the Exchange when considering a request to cancel or adjust a trade made in Bona Fide Error.
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\15\ See supra note 5.
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With respect to proposed paragraph (b)(3), the Exchange notes that this requirement is designed to balance the need to adequately ascertain the intent of all parties to an erroneous trade and to address the practical difficulty of an executing broker Participant attempting to directly verify the consent of such parties where the executing broker Participant received an order from an authorized agent of the parties to the trade and not from the parties directly. Under these circumstances, the Exchange submits that it is reasonable that the consent to cancel or adjust an erroneous trade may be given by the authorized agent(s) of those parties. With that said, the Exchange notes that under no circumstances shall the Exchange consider a request to cancel or adjust a Bona Fide Error trade without documentation verifying the intent of the parties to the erroneous trade to cancel or adjust the trade.
If the executing broker Participant satisfies all of the requirements of proposed paragraph (b) to the satisfaction of the Exchange, a request to cancel a trade made in Bona Fide Error would be approved. However, if the executing broker Participant were to request a trade adjustment, the Exchange would take additional steps to
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validate the proposed adjustment, pursuant to proposed paragraph (c).
Proposed paragraph (c) provides that a trade adjustment shall only be made to the extent necessary to correct the Bona Fide Error (i.e., to reflect the original terms of the order). The proposed paragraph continues by stating that prior to approving an adjustment, the Exchange shall validate that the proposed adjusted trade could have been executed in the Matching System at the time the trade was initially executed, in compliance with all applicable CHX and SEC rules. For instance, the validation process would require the Exchange to ensure that the proposed adjusted trade would not have improperly traded-through or ahead of interest resting on the Matching System (``CHX Book'') or a Protected Quotation of an external market in violation of Rule 611 of Regulation NMS.
Proposed paragraph (c) illustrates the benefit of a trade adjustment over a trade cancellation and the submission of an Error Correction Transaction.\16\ Assuming that a corrective trade would qualify as an Error Correction Transaction and be exempt from the trade-through prohibition of Rule 611 of Regulation NMS, such a corrective trade would still be subject to the state of the CHX Book as of the time the corrective trade was submitted. However, a validated trade adjustment would allow the executing broker Participant to preserve the timestamp of the original trade. Allowing the executing broker Participant to choose a trade cancellation or adjustment would allow for greater flexibility in determining the best course of action to rectify Bona Fide Errors.
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\16\ See supra note 4.
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Proposed paragraph (d) clarifies that if the Exchange approves a request for a trade cancellation or adjustment, any corrective action(s) necessary to effectuate the cancellation or adjustment, including corrective entries into the Exchange's records and/or corrective clearing submissions to a Qualified Clearing Agency, shall be taken solely by the Exchange operations personnel. This provision serves as a contrast to proposed paragraph (b), which places the responsibility for satisfying the T+1 requirement upon the executing broker Participant that submitted the erroneous trade.
The following Examples 1-3 illustrate how proposed Rule 9 would be applied under different scenarios.
Example 1. Assume that Broker A receives an order to buy 100,000 shares of security XYZ at $100.10/share. Assume that the Broker A wishes to match that order with a contra-side order that was placed with Broker A earlier that day. Assume that Broker A accurately conveys the terms of the cross order to Broker B, which is an executing broker Participant. However, assume that Broker B commits a good faith input error as to the price of the order and thus, an erroneous trade of 100,000 shares of security XYZ at $100.01 is executed on the Exchange.\17\
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\17\ Assuming that the reference price for security XYZ is approximately $100.10 per share, the erroneous trade would not qualify for cancellation as a Clearly Erroneous Transaction because the erroneous price of $100.01 does not meet the 3% threshold. See CHX Article 20, Rule 10(c).
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The price input error by Broker B would constitute a Bona Fide Error, pursuant to proposed Article 1, Rule 1(hh)(1) or (3), where the execution of the cross at the incorrect price is an ``inaccurate conveyance or execution of any term of an order, including, but not limited to, price'' and may also be the result of ``the incorrect entry of data into relevant systems.''
Moreover, if the parties to the erroneous trade wished to cancel the trade, Broker B would have to comply with the requirements of proposed Article 20, Rule 9(b) no later than 4:30 p.m. CST on T+1 or after T+1 with the approval of an officer of the Exchange. Specifically, pursuant to proposed paragraph (b)(1), Broker B must submit a Trade Error Report and a brief written request to cancel the erroneous trade. Also, pursuant to proposed paragraph (b)(2), Broker B must provide a brief explanation of the input error and produce documentation reflecting the original terms of the order. The documentation requirement could be satisfied, among other ways, by producing the internal order ticket from Broker A showing the price of $100.10 or a copy of a communication from Broker A to Broker B indicating the correct price and a timestamp prior to the CHX timestamp of the erroneous trade. In addition, pursuant to proposed paragraph (b)(3), Broker B would have to produce documentation evidencing consent to cancel the erroneous trade by the parties to the trade or, since Broker B did not interface directly with the parties to the erroneous trade, consent to cancel by Broker A, as authorized agent(s) of the parties to the trade.
Example 2. Assume the same as Example 1, except that the order price input error (i.e., $100.01, instead of $100.10) was committed by Broker A as an authorized agent of the parties to the erroneous trade and not by Broker B. Assume, therefore, that Broker B received the order with the incorrect price and, in turn, submitted the cross order to the Matching System resulting in an erroneous trade.
In this Example, the Bona Fide Error could be subject to proposed Rule 9 because proposed paragraph .02 contemplates Bona Fide Errors committed by the ``customer of the Participant that submitted the erroneous trade.'' However, in requesting the trade cancellation, Broker B would be required to provide all of the information as required by proposed paragraph (b) in a manner similar to Example 1, except that in addition to identifying the price misconveyance and the source of the error as being Broker A, Broker B would have to produce documentation of the original terms of the order as relayed to Broker A from each of the parties to the erroneous trade. As a general rule, the documentation showing the correct order terms should be verifiable to an objective source. That is, if the Bona Fide Error was committed by the executing broker Participant, the documentation showing the correct terms should be from the Participant's customer. If the Bona Fide Error was committed by the customer of the Participant, then an internal order ticket or similar documentation showing the correct terms as related to the customer of the Participant, would suffice.
Example 3. Assume the same as Example 2, except that the parties to the erroneous trade wished to adjust the trade to comport it with the original terms of the order (i.e., correct price of $100.10). Assume further that, at the time of the erroneous trade, the National Best Bid and Offer (``NBBO'') for security XYZ was $100.01 x $100.11 and the CHX Best Bid and Offer (``CHX BBO'') for security XYZ was at the NBBO. Assume also that the CHX best bid at $100.01 was for 100 shares and there are no undisplayed interests at or within the CHX BBO. In this case, like in Example 2, the executing broker Participant would have to satisfy the requirements of proposed paragraph (b).
In addition, pursuant to proposed paragraph (c), the Exchange would take the additional step of validating that the adjusted trade could have been executed in the Matching System at the time the erroneous trade was initially executed, in compliance with all applicable CHX and SEC rules. Thus, based on the aforementioned snapshot of the NBBO and the CHX BBO at the time of the erroneous trade, an adjustment of the price of the erroneous trade from $100.01 to the correct price of $100.10 would have complied with SEC and CHX rules, as of the time of the erroneous trade. Specifically, the adjusted trade would have complied
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with Rule 611 of Regulation NMS in that it would not have constituted a trade-through of a Protected Quotation of an external market as the adjusted price of $100.10 would have been within the NBBO of $100.01 x $100.11 at the time of the erroneous trade. Moreover, the adjusted trade would have complied with Article 20, Rule 8 in that the adjusted trade would not have improperly traded-through or ahead of interest resting on the CHX Book as the adjusted price of $100.10 would have been within the CHX BBO of $100.01 x $100.11.\18\
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\18\ Current Article 20, Rule 8(d)(1) states that ``except for certain orders which shall be executed as described in Rule 8(e), below, an incoming order shall be matched against one or more orders in the Matching System, in the order of their ranking, at the price of each resting order, for the full amount of shares available at that price, or for the size of the incoming order, if smaller.''
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As discussed above, Example 3 illustrates the primary benefit of a trade adjustment over a trade cancellation then corrective trade, which is to preserve the original timestamp of the trade. This is important because the NBBO and the CHX Book may have changed to the extent that a trade with the correct terms may no longer be executable. Even if the corrective trade qualifies as an Error Correction Transaction \19\ and is thereby able to trade-through the NBBO, if a subsequent order were to have posted to the CHX Book after the erroneous trade executed at a price that was the same as or better than the corrective trade, the corrective trade would nevertheless be blocked by the CHX Book.\20\ Trade adjustments avoid this problem by allowing the original trade to stand with adjustments to the trade to comport it to the original terms of the order, so long as the adjusted trade could be validated pursuant to proposed paragraph (c). Thus, the prevailing market and the state of the CHX Book as of the time of the adjustment become irrelevant.
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\19\ See Securities Exchange Act Release No. 55884 (June 8, 2007), 72 FR 32926 (June 14, 2007) (Order Exempting Certain Error Correction Transactions From Rule 611 of Regulation NMS Under the Securities Exchange Act of 1934).
\20\ For instance, where the order posted to the CHX Book after the erroneous trade and the corrective trade are priced the same, a corrective trade that qualifies for special handling as Cross With Size would execute ahead of such resting orders at the same price. See Article 20, Rule 2(g)(1).
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The Exchange submits that allowing such adjustments of Bona Fide Error trades would not harm other market participants because the result of an adjusted trade is identical to the original trade having been executed correctly. Indeed, trade adjustments ensure that parties to a trade are not penalized for Bona Fide Errors committed by authorized agent(s) or the executing broker Participant that submitted the erroneous trade. Furthermore, the Exchange submits that Bona Fide Error trade adjustments would be beneficial to the market as a whole in that it would prevent the excessive reporting of trades to the Consolidated Tape.\21\ When an erroneous trade is submitted, cancelled, then a corrective trade is submitted, the Consolidated Tape would reflect two order executions, thereby skewing the activity in that NMS stock. In contrast, a trade adjustment to the erroneous trade would result in only the original trade being reported. In addition, the Exchange notes that a trade adjustment would not harm other market participants because a trade adjustment is tantamount to the original trade having been made without Bona Fide Errors. That is, if the trade were adjusted to the correct terms, other market participants would be in the same position as if the trade had originally executed at the correct terms.
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\21\ The Exchange does not submit that ``excessive'' reporting to the tape would reflect inaccurate information. Rather, the Exchange believes that if trades were allowed to be adjusted under the circumstances proposed by this proposed rule filing, the tape could more efficiently represent market activity (e.g., reporting the initial trade and an adjustment to that trade, as opposed to reporting the initial trade, plus a cancellation of that trade, and a replacement trade).
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Finally, proposed paragraph (e) mirrors current Article 20, Rule 9(b)(5) which provides that failure to comply with the provisions of this Rule shall be considered conduct inconsistent with just and equitable principles of trade and a violation of Article 9, Rule 2.\22\ As the Exchange intends for the functionality provided by proposed Rule 9 to be utilized sparingly, the Exchange will continue its current market surveillance procedures to reasonably ensure that both Bona Fide Error trade cancellations and adjustments are properly utilized from both a basis and frequency perspective.
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\22\ CHX Article 9, Rule 2 (Just and Equitable Trade Principles) states as follows:
No Participant, Participant Firm or partner, officer, director or registered employee of a Participant Firm shall engage in conduct or proceeding inconsistent with just and equitable principles of trade. The willful violation of any provision of the Exchange Act or any rule or regulation thereunder shall be considered conduct or proceeding inconsistent with just and equitable principles of trade.
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Proposed Article 20, Rule 9A ``Error Correction Transactions''
Proposed Rule 9A adopts requirements for Error Correction Transactions (``ECT''), which are currently accepted by the Exchange, but the requirements of which are not detailed in the CHX rules.\23\ The proposed language virtually mirrors key portions of the ``Order Exempting Certain Error Correction Transactions From Rule 611 of Regulation NMS Under the Securities Exchange Act of 1934'' (``ECT order'').\24\
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\23\ The Exchange currently accepts ECTs, provided that, inter alia, the ECT is marked by a special Bone Fide Error trade indicator and the Participant submits a Trade Error Report to the Exchange.
\24\ See supra note 19.
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Specifically, proposed paragraph (a) provides that a Participant may submit an ECT to remedy the execution of customer orders that have been placed in error, provided that the following requirements are satisfied:
(1) The erroneous transaction was the result of a ``Bona Fide Error,'' as defined under proposed Article 1, Rule 1(hh);
(2) The Bona Fide Error is evidenced by objective facts and circumstances and the Participant maintains documentation of such facts and circumstances;
(3) The Participant recorded the ECT in its error account;
(4) The Participant established, maintained, and enforced written policies and procedures that were reasonably designed to address the occurrence of errors and, in the event of an error, the use and terms of an ECT to correct the error in compliance with this Rule; and
(5) The Participant regularly surveiled to ascertain the effectiveness of its policies and procedures to address errors and transactions to correct errors and took prompt action to remedy deficiencies in such policies and procedures.
Proposed paragraph (b) states that an ECT may execute without the restrictions of the trade-through prohibition of Rule 611, provided that the ECT is marked with a special Bona Fide Error trade indicator.\25\ Proposed paragraph (b) further states that this exemption applies only to the ECT itself and does not, for example, apply to any subsequent trades made by a Participant to eliminate a proprietary position connected with the ECT. Aside from the language requiring that ECTs be marked with a special trade indicator, the proposed language virtually mirrors language from the ECT order.
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\25\ See supra note 23.
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Similar to proposed Article 20, Rule 9(e), proposed paragraph (c) provides that failure to comply with the provisions of this Rule shall be considered conduct inconsistent with
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just and equitable principles of trade and a violation of Article 9, Rule 2.\26\
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\26\ See supra note 22.
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Within the context of the proposed CHX trade cancellation and adjustment matrix, proposed Rule 9A addresses a few specific situations. First, ECTs are typically used to submit corrective trades after a trade based on Bona Fide Error had been cancelled or to submit a trade where the original order was never submitted (i.e., a ``missed market'' situation).\27\ ECTs can also provide a corrective remedy where there is a Bona Fide Error trade, as defined under proposed Article 1, Rule 1(hh), but a trade cancellation or adjustment pursuant to proposed Rule 9 is not possible, due to the fact that there is not unanimous consent of all parties to the trade to cancel or adjust (e.g., Bona Fide Error was committed by the executing broker Participant with respect to a single-sided order). In such a case, the erroneous trade would be taken into the error account of the executing broker Participant, as opposed to being cancelled. However, if the erroneous trade were cancelled as a Clearly Erroneous Transaction \28\ without the unanimous consent of all parties to the trade, an ECT could be affected without the executing broker Participant having to take the erroneous trade into its error account. Thus, proposed Rule 9A, read together with current Article 20, Rule 9 and Rule 10, contemplates a wide array of remedies to correct Bona Fide or Obvious Errors.
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\27\ The Exchange notes that ``absent a bona fide error as defined above, the exemption does not apply to a broker-dealer's mere failure to execute a not-held order in accordance with a customer's expectations.'' Securities Exchange Act Release No. 55884 (June 8, 2007), 72 FR 32926, 32927 (June 14, 2007), note 14.
\28\ See CHX Article 20, Rule 10.
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Proposed Article 20, Rule 11 ``Cancellation or Adjustment of Stock Leg Trades''
The Exchange proposes to adopt Article 20, Rule 11 (``Cancellation or Adjustment of Stock Leg Trades'') to expand and clarify current Article 20, Rule 9(b), which outlines the requirements for the cancellation of the stock leg of Stock-Option orders. In addition to adopting much of current Article 20, Rule 9(b), proposed Rule 11 expands the circumstances under which stock leg trades may be cancelled, adopts new requirements to allow for the adjustment of stock leg trades and includes Stock-Future orders within the purview of the proposed Rule.
Proposed Rule 11(a) adopts current Article 20, Rule 9(b)(6) and provides a general overview of the scope of the proposed Rule. Specifically, it states that unless otherwise expressly prohibited by the Exchange's rules, a trade representing the stock leg of a Stock-
Option combination order, as defined under proposed Article 1, Rule 1(ii) or a Stock Future combination order, as defined under Article 1, Rule 1(jj), may be subject to cancellation or adjustment by the Exchange pursuant to proposed Rule 11, if the stock leg trade was marked by a special trade indicator when it was originally submitted to the Matching System.\29\ The proposed paragraph further clarifies that if the stock leg trade was not originally marked by a special trade indicator, the trade shall not be eligible for cancellation or adjustment, notwithstanding compliance with the other requirements of this Rule.
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\29\ Current Article 20, Rule 9(b)(6) requires ``any transactions cancelled pursuant to the provisions of this section must be identified by a special trade indicator.''
The purpose of the special trade indicator is to mark a stock leg trade as being part of a Stock-Option order and consequently notifies the market after execution that the trade may be cancelled, as the trade is contingent upon the execution of non-stock legs that comprise the total Stock-Option combination order.
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Proposed Article 1, Rule 1(ii) provides a definition for ``Stock-
Option'' combination orders. Specifically, the proposed definition of ``Stock-Option'' order simplifies current Article 20, Rule 9(b)(2) \30\ and provides that ``Stock-Option'' is a combination order where at least one component is a cross order for a stated number of units of an underlying or related security coupled with the purchase or sale of options contract(s) on the opposite side of the market representing at least the same number of units as the underlying or related security portion of the order. The Exchange submits that this simplified definition encompasses the hedging scenarios described in current Article 20, Rule 9(b)(2)(i) and (ii), as illustrated in the examples below.
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\30\ Current Article 20, Rule 9(b)(2) states as follows:
For purposes of this Rule, a 'stock-option order' is an order to buy or sell a stated number of units of an underlying or a related security coupled with either (i) the purchase or sale of option contract(s) on the opposite side of the market representing either the same number of units of the underlying or related security or the number of units of the underlying security necessary to create a delta-neutral or delta-hedged position or (ii) the purchase or sale of an equal number of put and call option contracts, each having the same exercise price, expiration date and each representing the same number of units of stock as, and on the opposite side of the market from, the underlying or related security portion of the order.
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The Exchange notes that all cross orders marked as Qualified Contingent Trades (``QCTs'') \31\ received by the Matching System would qualify as a Stock-Option or Stock-Future order and thus be eligible for cancellation or adjustment pursuant to proposed Rule 11.\32\ However, it is important to note that not every Stock-Option or Stock-
Future order would qualify as a QCT because the definition of Stock-
Option/Stock-Future does not require the contemporaneous or near contemporaneous execution of the different components. Therefore, maintaining the distinction between QCT and Stock-Option/Stock-Future orders is important, in light of the fact that a stock leg trade that qualifies as QCT is exempt from Rule 611(a) of Regulation NMS, whereas a stock leg trade that is part of a Stock-Option or Stock-Future combination order may be cancelled or adjusted pursuant to proposed Rule 11.
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\31\ See Securities Exchange Act Release No. 54389 (August 31, 2006), 71 FR 52829 (September 7, 2006) (``Order Granting an Exemption for Qualified Contingent Trades From Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 1934''); see also Securities Exchange Act Release No. 57620 (April 4, 2008), 73 FR 19271 (April 4, 2008) (``Order Modifying the Exemption for Qualified Contingent Trades From Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 1934''); see also Article 1, Rule 2(b)(2)(E).
\32\ The QCT requirement that ``the Exempted NMS Stock Transaction is fully hedged (without regard to any prior existing position) as a result of the other component of the contingent trade'' is similar to the proposed requirement for Stock-Option/
Stock-Future orders that the stock leg trade be couple with ``options contract(s) on the opposite side of the market representing at least the same number of units as the underlying or related security portion of the order.'' See CHX Article 1, Rule 2(b)(2)(E).
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The following Examples 1-3 illustrate which combination orders would comport with the proposed definition of ``Stock-Option'' orders.
Example 1. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 1,000,000 shares of XYZ
Sell 10,000 XYZ Jan 50 call options
In this Example, the stock position on the long side of the market is hedged on a share-by-share basis by the options position on the short side of the market, because the stock position represents the same number of units as the options position (i.e., 1,000,000 shares of XYZ on the long side against 10,000 XYZ call options representing 1,000,000 shares of XYZ on the short side). Thus, this combination order is a ``Stock-Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call options represent ``at least the same number of units as the underlying or related security portion of the order.''
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Example 2. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 470,000 shares of XYZ
Sell 10,000 XYZ Jan 50 call options
Assume further that the call options have a delta value of 0.47. In this Example, the stock position on the long side of the market is hedged on a share-by-share basis by the options position on the short side of the market, because the stock position represents fewer units than the options position (i.e., 470,000 shares of XYZ on the long side against 10,000 XYZ call options representing 1,000,000 shares of XYZ on the short side). Thus, this combination order is a ``Stock-Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call options represent ``at least the same number of units as the underlying or related security portion of the order.'' Moreover, this Example illustrates that a delta-neutral hedge will fall within the proposed definition. That is, since a delta value can never exceed 1, a delta-neutral hedge will never result in a stock position being less than hedged on a share-by-share basis by the options position.
Example 3. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 2,000,000 shares of XYZ
Sell 10,000 XYZ Jan 50 call options
In this Example, the stock position on the long side of the market is not hedged on a share-by-share basis by the options position on the short side of the market, because the stock position represents a greater number of units than the options position (i.e., 2,000,000 shares of XYZ on the long side against 10,000 XYZ call options representing 1,000,000 shares of XYZ on the short side). Thus, this combination order is not a ``Stock-Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call options do not represent ``at least the same number of units as the underlying or related security portion of the order.''
In sum, Examples 1-3 illustrate that if the long (short) stock position is hedged on at least a share-by-share basis by the short (long) options position(s), the combination order will meet the proposed definition of ``Stock-Option.'' Moreover, the following Examples 4-7 illustrate situations where there are more than one options positions, such as the scenario described under current Article 20, Rule 9(b)(2)(ii) and how such multiple options positions would fit under the proposed definition of ``Stock-Option'' order.
Example 4. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 1,000,000 shares of XYZ
Sell 10,000 XYZ Jan 50 call options
Buy 10,000 XYZ Jan 50 put options
This is an example of the type of order contemplated by current Article 20, Rule 9(b)(2)(ii). That is, the positions in this Example 4 represent the purchase or sale of an equal number of put and call option contracts (i.e., 10,000 contracts each), each having the same exercise price (i.e., $50.00), expiration date (i.e., January) and each representing the same number of units of stock as, and on the opposite side of the market from, the underlying or related security portion of the order (i.e., each option represents 1,000,000 shares on the short side of the market opposite of the 1,000,000 shares on the long side market).
This order fits within the proposed definition of ``Stock-Option'' because each one of the options legs are on the opposite side of the market from the stock leg and each represent ``at least the same number of units as the underlying or related security portion of the order.''
Example 5. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 1,000,000 shares of XYZ
Sell 6,000 XYZ Jan 50 call options
Buy 4,000 XYZ Jan 50 put options
This order also fits within the proposed definition of ``Stock-Option'' because the stock position on the long side of the market is hedged on a share-by-share basis by the sum of the two options position on the short side of the market, because the stock position represents the same number of units as the options position (i.e., buy 1,000,000 shares of XYZ on the long side against sell 6,000 XYZ call options and buy 4,000 XYZ put options, together representing 1,000,000 shares of XYZ on the short side). Thus, this combination order is a ``Stock-
Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call and put options together represent ``at least the same number of units as the underlying or related security portion of the order.''
Another way to visualize this trade is to break up the order into two separate Stock-Option orders:
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Stock-Option Order 1 i>2
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Buy 600,000 shares of XYZ................. Buy 400,000 shares of XYZ.
Sell 6,000 XYZ Jan 50 call options........ Buy 4,000 XYZ Jan 50 put
options.
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Each one of the stock leg components are hedged on a share-by-share basis by options contracts on the opposite side of the market representing exactly the same number of shares as the stock leg.
Example 6. Assume that a combination order is presented as follows and the contra-parties to the stock and options legs are the same:
Buy 1,000,000 shares of XYZ
Sell 5,000 XYZ Jan 50 call options
Sell 5,000 XYZ Jan 50 put options
In this Example, the stock position and the XYZ Jan 50 put options are on the long side of the market, while the XYZ Jan 50 call is on the short side of the market. Since the proposed definition of ``Stock-
Option'' is only concerned about the stock position being hedged by options on the opposite side of the market, and not additional options positions on the same side of the market as the stock position, any options positions on the same side of the market as the stock position would be ignored. After excluding the XYZ Jan 50 put options from the analysis, we are left with a stock position on the long side that is not hedged on a share-by-share basis by the options position on the short side, because the stock position represents a greater number of units than the options position (i.e., buy 1,000,000 shares of XYZ on the long side against sell 5,000 XYZ call options representing 500,000 shares of XYZ on the short side). Thus, this combination order is not a ``Stock-Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call options do not represent ``at least the same number of units as the underlying or related security portion of the order.''
Example 7. Assume the same as Example 6, except that the call options on the short side of the market were for 20,000 contracts representing 2,000,000 shares of XYZ. As in Example 6, the put options on the long side of the market would be ignored. We are then left with a stock position on the long side that is smaller than the call options position on the short side (i.e., buy 1,000,000 shares of XYZ on the long side against 20,000 XYZ call options representing 2,000,000 shares of XYZ on the short side). Thus, this combination order is a ``Stock-
Option'' order as defined under proposed Article 1, Rule 1(ii), because the short side call options represent ``at least the same number of units as the underlying or related security portion of the order.''
Page 57438
With respect to the proposed definition of ``Stock-Future'' order, proposed Article 1, Rule 1(jj) provides that it is a combination order where at least one component is a cross order for a stated number of units of an underlying or a related security coupled with the purchase or sale of futures contract(s) on the opposite side of the market representing at least the same number of units of the underlying or related security portion of the order.\33\ Similar to the proposed definition for ``Stock-Option'' orders, this definition establishes a bright-line requirement for the size of the futures transaction, so as to prevent misuse of this proposed Rule (i.e., the use of de minimis amount of future contracts to allow a stock order to be subject to cancellation or adjustment). Given that Stock-Future orders can also be QCTs, the Exchange submits that making the definitions of ``Stock-
Option'' and ``Stock-Future'' orders nearly identical is appropriate.
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\33\ For example, a trade on the CHX in the SPDR S&P 500 ETF Trust (symbol SPY) may be related to a transaction in an S&P 500 futures contract.
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Cancellation of Stock Leg Trades
Proposed Rule 11(b) outlines the requirements for the requests to cancel a stock leg trade. Specifically, paragraph (b)(1) incorporates and expands the first half of current Article 20, Rule 9(b)(1),\34\ and provides that the Exchange may approve a request to cancel a stock leg trade that was originally marked by a special trade indicator and take the corrective action(s) necessary to effectuate such a cancellation, provided that the following items are submitted to the Exchange, in a form prescribed by the Exchange, by the Participant that submitted the stock leg trade. It further provides that the requirements of this paragraph (b) must be complied with to the satisfaction of the Exchange, before a stock leg trade cancellation pursuant to this Rule may be approved or any corrective action may be taken. In addition, the Exchange shall have sole discretion in determining whether the requirements of this Rule have been satisfied. Thereunder, proposed subparagraphs (A)-(C) require the following:
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\34\ Current CHX Article 20, Rule 9(b)(1) states as follows:
Unless otherwise expressly permitted by the Exchange's rules, a trade representing the execution of the stock leg of a stock-option order may be cancelled at the request of all Participants that are parties to that trade if (i) market conditions in any of the non-
Exchange market(s) prevent the execution of the option leg(s) at the price agreed upon by the parties to the options leg, or (ii) the options leg(s) is cancelled by the exchange on which it was executed.
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(A) Timely written request. The Participant that submitted the stock leg trade shall submit a written request for cancellation, including all information and supporting documentation required by this Rule, no later than 4:30 p.m. CST on T+1. The Exchange will retain a copy of the written request, information, and supporting documentation. In extraordinary circumstances, a cancellation may be requested and effected after T+1, with the approval of an officer of the Exchange;
(B) Qualified Cancellation Basis. The Participant that submitted the stock leg trade shall identify the Qualified Cancellation Basis, as defined under proposed paragraph (b)(2). The Participant shall also provide and maintain supporting documentation showing the objective facts and circumstances supporting the Qualified Cancellation Basis; and
(C) All parties consent. The Exchange shall verify that the cancellation is requested by all parties involved in the stock leg trade (or by an authorized agent of those parties). The Participant that submitted the stock leg trade shall provide supporting documentation evidencing this consent.
Similar to proposed Rule 9(b)(1), proposed subparagraph (A) sets a time limit for requests to cancel a stock leg trade of a Stock-Option/
Stock-Future order. The time requirement is short enough to encourage quick resolution, while being long enough to accommodate unforeseen circumstances. Thus, similar to proposed Rule 9(b)(1), the Exchange will not consider any request to cancel a stock leg trade, much less take any corrective action to effectuate such a cancellation, until all of the requirements of proposed Rule 11 are satisfied.
Similar to proposed Rule 9(b)(2), proposed subparagraph (B) requires the Participant that submitted the stock leg trade to identify the specific reason for the requested cancellation, which in the context of Stock-Option/Stock-Future combination orders would at least be one of the ``Qualified Cancellation Basis,'' as discussed in detail below. Moreover, like proposed Rule 9(b)(2), the Participant that submitted the stock leg trade is responsible for providing all documentation that supports the Qualified Cancellation Basis. For instance, if the reason for the stock leg trade cancellation is that the non-stock leg executed at a price other than what was originally agreed, the Participant that submitted the stock leg trade would have to produce documentation reflecting the original non-stock leg terms and a copy of the original order ticket that reflects the non-stock leg trade as actually executed.
Similar to proposed Rule 9(b)(3), proposed subparagraph (C) requires the Exchange to verify that the request to cancel the stock leg trade is consented to by the parties to the stock leg trade or by an authorized agent(s) of the parties. However, the Participant that submitted the stock leg trade must provide the supporting documentation evidencing this consent to cancel (e.g., email or instant message) from either the parties to the trade or by an authorized agent of the parties.
As referred to in proposed Rule 11(b)(1)(B) above, proposed Rule 11(b)(2) lists the ``Qualified Cancellation Basis'' as follows:
(A) A non-stock leg executed at a price/quantity or was adjusted to a price/quantity other than the price/quantity originally agreed upon by all of the parties to the Stock-Option or Stock-Future order;
(B) A non-stock leg could not be executed; or
(C) A non-stock leg was cancelled by the exchange on which it was executed.
While proposed subparagraph (C) substantively mirrors current Article 20, Rule 9(b)(1)(ii), proposed subparagraphs (A) and (B) expands the permissible circumstances where a stock leg trade may be cancelled.
Proposed subparagraph (A) is based on current Article 20, Rule 9(b)(1)(i), but expands its scope. Specifically, proposed subparagraph (A) eliminates the overly narrow reference to ``market conditions'' and includes execution of the non-stock leg at a size other than what was originally agreed as a basis to cancellation of the stock leg. That is, in addition to situations where market conditions prevent the execution of the non-stock leg at the originally agreed price (e.g., NBBO changes), the proposed subparagraph (A) contemplates situations where the parties voluntarily adjust the terms of non-stock leg trade or modify the terms of the non-stock leg order prior to execution, with the intention of modifying the original stock leg terms. If all of the components are executed at the modified terms, there would be no need to cancel trades. However, given the latency inherent in the Stock-
Option/Stock-Future order handling and execution process,\35\ it is frequently the
Page 57439
case that modification instructions fail to reach the Participant that submitted the stock leg trade on the Exchange, prior to the stock leg executing at the original terms.
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\35\ When parties to a Stock-Option/Stock-Future order agree to the terms, the individual components are virtually never executed simultaneously, due to the fact that derivative legs and stock legs are executed on different venues. Thus, the order packaging process frequently involves numerous brokers relaying order instructions for component orders that are to be executed at different venues. In the situation where a Stock-Option order originates on the floor of an options exchange or a Stock-Future order originates on the floor of a futures exchange, the relaying of stock leg order information will likely go from the floor brokers to an inter-dealer broker, who in turn will relay the information to an executing broker Participant. In such a case, there will be an inherent latency in communication in the process.
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For instance, a voluntary modification of the terms of a Stock-
Option order may arise if one or more parties to the order withdrew from the order prior to execution of any components. In such an instance, the remaining parties would have to either cancel the entire Stock-Option order or attempt to modify the terms of the order to compensate for the lost parties. If the parties chose to attempt to modify the terms of the Stock-Option order, there may be a situation where the non-stock leg would execute at the modified terms, but the stock leg trade would execute at the original terms, before the modified stock leg terms were received by the Participant that submitted the stock leg trade. Thus, the stock leg trade would likely be inadequately hedged \36\ by the options position. In the worst case scenario, the stock leg may have traded-through a Protected Quotation without being ``fully hedged,'' as required by the QCT exemption.\37\ In such a case, the parties may wish to either adjust the stock leg trade, pursuant to proposed Article 20, Rule 11(c), as discussed in detail below, or simply cancel the original stock leg trade and replace the trade with a stock leg trade that is adequately hedged by the modified non-stock leg trade.\38\ Thus, by expanding current Article 20, Rule 9(b)(1)(i) to include all situations where a non-stock leg executed at a price/quantity other than what was originally agreed, the communication latency issues can be effectively mitigated and market participants can be protected from being penalized for engaging in bona fide market activity.
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\36\ An ``inadequate'' hedge means a hedge ratio that deviates from what has been agreed by the parties to the Stock-Option/Stock-
Future order or a hedge that is not a ``fully hedged'' position, as required and defined by the QCT exemption. See supra note 31.
\37\ See supra note 31.
\38\ The parties may decide that it would be more desirable to cancel the stock leg trade, given the additional requirements that must be met for a trade adjustment to be approved pursuant to proposed Article 20, Rule 11(c), especially if the replacement stock leg trade would not trade-through a Protected Quotation of an external market.
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Proposed subparagraph (B) adopts a new Qualified Cancellation Basis where a stock leg trade may be cancelled if the non-stock leg was never executed. There are numerous reasons why a non-stock leg trade may not be executed. For instance, market conditions may block the execution of an options leg at the originally agreed price, and instead of executing at a price other than what was originally agreed, the parties may simply cancel the non-stock leg order. Also, one or more parties to a Stock-Option/Stock-Future order may decide not to participate in the Stock-Option order prior to any of the component orders being executed. In this case, instead of trying to modify the terms of the Stock-Option order to compensate for the lost parties, as discussed above, the remaining parties may decide that it would be best to cancel the entire order. If the parties decide to cancel the Stock-Option order, the cancel messages may reach the respective executing brokers in time, thus obviating the need to cancel trades. However, due to the inherent communication latency,\39\ it is frequently the case that the non-stock leg order is cancelled prior to execution, but the cancel message does not reach the Exchange prior to the stock leg being executed. In such a situation, it would be patently unfair to require the parties to the Stock-Option/Stock-Future order to maintain a stock position that is no longer hedged by a non-stock position, especially if the stock leg relied on the QCT exemption to trade-through a Protected Quotation of an external market.
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\39\ See supra note 35.
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Moreover, the Exchange submits that any potential abuse of proposed subparagraph (B) is reasonably eliminated by the requirement that all parties to the Stock-Option order consent to the stock leg trade cancellation. Thus, since no one contra-party may act unilaterally to cancel a trade, this would prevent any one contra-party from cancelling a stock leg trade where stock prices or options prices moved in favor of that party. It logically flows that if prices move in favor of one party, the prices have moved to disadvantage of the contra-party. Under such circumstances, the contra-party would never agree to a stock leg trade cancellation.
The Exchange submits that the proposed Qualified Cancellation Bases, when considered as a whole, adequately address the latency issues that affect the Stock-Option/Stock-Future order packaging process. By expanding the permissible bases for cancelling stock leg trades, the problems arising from these latency issues can be resolved by allowing market participants to step away from unwanted stock positions when certain contingencies are not realized.
Adjustments of Stock Leg Trades
The Exchange submits that when a non-stock leg executes at different terms than originally agreed or is adjusted by the exchange, it may be more appropriate to permit the adjustment of the stock leg trade to maintain the original aggregate cash flow \40\ or original hedge ratio of the Stock-Option or Stock-Future order that was agreed upon by all of the parties, as opposed to cancelling the stock leg trade and requiring the parties to attempt to execute the entire package again. So long as the adjustment is consistent with original intent of the parties that can be reasonably ascertained, the Exchange submits that allowing adjustments can prove to be a valuable tool in promoting order flow to the Exchange and preventing the excessive reporting of activity to the tape.\41\
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\40\ The ``original aggregate cash flow'' of a Stock-Option or Stock Future order is the absolute value of the difference between the cash flow of the proposed stock leg trade and the proposed non-
stock leg trade had the Stock-Option or Stock-Future order been executed as originally intended. See infra Example 8.
\41\ See supra note 21.
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Proposed paragraph (c) adopts new requirements to allow for the adjustment of a stock leg trade that is a component of a Stock-Option/
Stock-Future order under specified circumstances. The format of proposed paragraph (c) is modeled on proposed paragraph (b), with additional substance to address the added complexity of adjusting trades. Similar to proposed paragraph (b)(1), proposed paragraph (c)(1) provides that the Exchange may approve a request to adjust a stock leg trade that was originally marked by a special trade indicator and take the corrective action(s) necessary to effectuate such an adjustment, provided that the following items are submitted to the Exchange, in a form prescribed by the Exchange, by the Participant that submitted the stock leg trade. It further states that the requirements of this proposed paragraph (c) must be complied with, to the satisfaction of the Exchange, before a stock leg trade adjustment pursuant to this Rule may be approved or any corrective action may be taken. Thereunder, proposed subparagraphs (A)-(D) require the following:
(A) Timely written request. The Participant that submitted the stock leg trade shall submit a written request for adjustment, including all information and supporting documentation required by this Rule, no later than 4:30 p.m. CST
Page 57440
on T+1. The Exchange will retain a copy of the written request, information, and supporting documentation. In extraordinary circumstances, an adjustment may be requested and effected after T+1, with the approval of an officer of the Exchange;
(B) Qualified Adjustment Basis. The Participant that submitted the stock leg trade shall identify the Qualified Adjustment Basis, as defined under proposed paragraph (c)(2). The Participant shall also provide and maintain supporting documentation showing the objective facts and circumstances supporting the Qualified Adjustment Basis;
(C) All parties consent. The Exchange shall verify that the adjustment is requested by all parties involved in the stock leg trade (or by an authorized agent of those parties). The Participant that submitted the stock leg trade shall provide supporting documentation evidencing this consent; and
(D) Additional Documentation. The Participant that submitted the stock leg trade shall submit a proposed Adjusted Stock Price or Adjusted Stock Quantity, as detailed under proposed paragraph (c)(3).
Similar to proposed paragraph (b)(1)(A)-(C), proposed subparagraphs (c)(1)(A)-(C) establishes time, basis, consent, and documentation requirements for proposed stock leg trade adjustments. Proposed subparagraph (D) establishes an additional documentation requirement for proposed stock leg trade adjustments that requires the Participant that submitted the stock leg trade to provide certain information and calculations to show that the proposed adjustment are necessary and appropriate (i.e., Adjusted Stock Price for price adjustments and Adjusted Stock Quantity for quantity adjustments) and comport with the requirements of proposed paragraph (c)(3).
As referred to in proposed Rule 11(c)(1)(B) above, proposed paragraph (c)(2) provides that a ``Qualified Adjustment Basis'' exists if a non-stock leg executed at a price/quantity or was adjusted to a price/quantity other than the price/quantity originally agreed upon by all of the parties to the Stock-Option or Stock-Future order. Proposed paragraph (c)(2) is identical to proposed paragraph (b)(2)(A). If the non-stock leg were to execute or be adjusted to price/quantity other than what was originally agreed, the parties to the stock leg trade would have the choice of either cancelling the stock leg trade or adjusting the stock leg trade to match the original aggregate cash flow or the original hedge ratio of the Stock-Option or Stock-Future order. Adjustments under such circumstances would obviate the need to cancel component trades that have been properly executed and would be a more efficient use of market resources. Moreover, adjustments would also have the additional benefit of avoiding excessive reporting to the tape.\42\
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\42\ Id.
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In order to reasonably ensure that adjustments to the stock leg trade are made consistently and comport to the original intent of the parties, a detailed methodology for determining and verifying exact adjusted terms is essential. To this end, proposed paragraph (c)(3) provides that the Participant that submitted the stock leg trade may request only one of the following adjustments per Stock-Option or Stock-Future order. Moreover, pursuant to proposed paragraph (c)(1)(D), the Participant shall provide the applicable information and calculations to the Exchange in a form prescribed by the Exchange.
Proposed subparagraph (A) details the necessary calculations for Adjusted Stock Price, where a non-stock leg executed at a price or was adjusted to a price other than the price originally agreed upon by all of the parties to the Stock-Option or Stock-Future order and the parties wish to maintain the original aggregate cash flow of the Stock-
Option or Stock-Future order. Thereunder, subparagraphs (A)(i)-(iv) require the Participant that submitted the stock leg trade to submit:
(i) the aggregate cash flow of the Stock-Option or Stock-Future order based on trade prices had it been fully executed at the original terms agreed upon by all of the parties to the Stock-Option or Stock-
Future order, prior to any component trade having been executed;
(ii) the actual aggregate cash flow of the executed non-stock leg(s);
(iii) the Comparable Stock Price (``CSP'') for the stock leg which would result in exactly the same aggregate cash flow as indicated under subparagraph (i);
(iv) the proposed Adjusted Stock Price (``ASP'') that comports with the following formula:
(CSP-$0.015) Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to rule-comments@sec.gov. Please include File Number SR- CHX-2013-16 on the subject line.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.
All submissions should refer to File Number SR-CHX-2013-16. This file number should be included on the subject line if email 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 (http://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 Web site viewing and printing in the Commission's Public Reference Room on official business days between the hours of 10:00 a.m. and 3:00 p.m. Copies of such filing also will be available for inspection and copying at the principal offices of CHX. 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-CHX-2013-16, and should be submitted on or before October 9, 2013.
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\58\ 17 CFR 200.30-3(a)(12).
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.\58\
Kevin M. O'Neill,
Deputy Secretary.
FR Doc. 2013-22648 Filed 9-17-13; 8:45 am
BILLING CODE 8011-01-P
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