(12)
`
`United States Patent
`Gary
`
`(10) Patent N0.:
`(45) Date of Patent:
`
`US 6,618,707 B1
`Sep. 9, 2003
`
`US006618707B1
`
`(54) AUTOMATED EXCHANGE FOR TRADING
`DERIVATIVE SECURITIES
`
`(75) Inventor: Katz Gary, Plainview, NY (Us)
`
`(73) Assignee: International Securities Exchange,
`Inc., NeW York, NY (US)
`
`( * ) Notice:
`
`Subject to any disclaimer, the term of this
`.
`.
`patent is extended or adJusted under 35
`U.S.C. 154(b) by 0 days.
`
`(21) Appl. No.: 09/433,613
`_
`(22) Flled:
`
`NOV‘ 2’ 1999
`Related US‘ Application Data
`(60) Provisional a “Cation NO 60/106 935 ?led on NOV 3
`1998'
`pp
`'
`’
`’
`'
`’
`
`(51) Im. c1.7 .............................................. .. G06F 17/60
`(52) US. Cl. .......................................... .. 705/37; 705/36
`of Search ............................. ..
`36,
`
`(56)
`
`References Cited
`
`1/2000 Minton ...................... .. 705/37
`6,014,643 A
`6,016,483 A * 1/2000 Rickard et al. ............. .. 705/37
`6,035,288 A
`3/2000 Solomon .......... ..
`705/37
`6,076,068 A
`6/2000 DeLapa et al.
`705/14
`6,112,189 A * 8/2000 Rickard et al. ............. .. 705/37
`FOREIGN PATENT DOCUMENTS
`
`W0
`
`WO 93/15467
`3342591
`
`/38844
`
`8/1993
`11/1997
`
`9/1998
`
`OTHER PUBLICATIONS
`Management Science, vol. 43, No. 12, Dec. 1997, Eric K.
`Clemons, Information Technology and Screen—Based Secu
`rities Trading.
`Wall Street & Technology, vol. 15, No. 3, Mar. 1997,
`Schmerken, Ivy, “The Pandora’s Box over Autoquotes.”
`How is a Trade Executed—L1m1t Order. Printed from the
`Nasdaq Web Page on Mar. 7, 2000.
`
`(List Continued On next page)
`Primary Examiner_EriC W_ Stamber
`Assistant Examiner_JOhn Leonard Young
`(74) Attorney, Agent, or Firm—Stephen J. Lieb; Frommer,
`Lawrence & Hang LLP
`
`US. PATENT DOCUMENTS
`
`(57)
`
`ABSTRACT
`
`4/1971 Adams et al- --------- -- 340/172-5
`3,573,747 A
`5/1971 Nymeyer ~~~~~~~~ ~~
`235/152
`3,581,072 A
`4312287 A 10/1983 Braddock’ HI
`364/408
`4’674’044 A
`6/1987 Kalmus et a1‘
`364/408
`4,903,201 A
`2/1990 Wagner ...... ..
`364/408
`4,980,826 A 12/1990 Wagner ______ n
`364/408
`5,101,353 A
`3/1992 Lupien et aL
`364/408
`5,136,501 A
`8/1992 Silverman et a1_
`364/408
`5,297,032 A
`3/1994 Trojan et a1,
`364/408
`5,305,200 A
`4/1994 Hartheimer et al.
`.. 364/408
`
`. . . ..
`5,664,115 A
`9/1997 Fraser . . . . . . . . . . . . . .
`395/237
`576897652 A 11/1997 LuPien ct a1~ -
`5,715,402 A
`2/1998 Popolo ..................... .. 395/237
`5,787,402 A
`7/1998 Potter et al. ................ .. 705/37
`5,905,974 A
`5/1999 Fraser et al.
`705/37
`5,913,202 A
`6/1999 Motoyama _ _ _ _ _ _ _ _
`_ _ _ N 70565
`5,924,082 A
`7/1999 Silverman et al.
`705/37
`5,946,666 A * 8/1999 Nevo etal. ................. .. 705/36
`5,970,479 A 10/1999 Shepherd ................... .. 705/37
`5,978,779 A 11/1999 Stein et al. ................. .. 705/37
`
`An automated exchange is provided for matching incoming
`orders for the purchase or sale of ?nancial instruments, such
`as options contracts, With previously received orders. The
`h
`llocates the matchin of orders ?rst to ?ll cus
`6X6 ange a
`g .
`tomer orders and then to ?ll professional orders on a pro rata
`basis. A primary market maker is given preference over
`other market professionals. Market professionals that enter
`larger orders into the book receive a proportionally larger
`portion of the incoming order. The exchange automatically
`
`maintains a minimum Size
`deriving Orders for profes_
`sionals across a range of prices When orders at the market
`price are exhausted' The eXchange automatically derives
`Orders for professionals to join With markemmproving
`.
`.
`orders When the market-improving orders are less than the
`mlmmum market SlZe
`
`75 Claims, 23 Drawing Sheets
`
`7
`
`5
`
`a
`
`cerrrpererrve
`
`Market Makem
`(CMM 1)
`
`stem/e
`Marker Maker 82
`L (CMM 21
`
`.
`
`7 if
`
`PM“ Mame‘
`Make’
`(PMM)
`
`9
`
`Elecimmc Access
`Member
`,
`(EAMJ
`‘
`
`E
`Xchinge
`E)
`
`‘
`
`J
`
`‘3
`ri r
`
`1‘ Customer
`(cos) i
`
`15
`
`Customer ‘
`
`(cus) i
`
`12
`Thlld Parry Connection
`servree Pmvlder
`1
`
`11
`
`Eleqmnic Awess
`Member
`(EAM)
`
`21
`
`Clearance ‘
`Emmy
`
`19
`Reporting
`may
`
`17
`“1
`
`Away Market
`
`Marxel Maker on Away
`MameHFARMM)
`
`‘
`
`,
`
`Cisco Systems, Inc., EX 1152 Page 1
`
`

`

`US 6,618,707 B1
`Page 2
`
`OTHER PUBLICATIONS
`
`HoW is a Trade EXecuted—Market Order. Printed from the
`Nasdaq Web Page on Mar. 7, 2000.
`Cosgrove, Suzanne. Courting Retail, Institutional Custorn
`ers, CBOE , AMEX Get Creative. Knight—Ridder Financial
`News, Jan. 29, 1993.
`Michaels, George. Distributed Electronic Ordering System,
`?nancial software from Financial Technology Corp. Wall
`Street Cornputer RevieW, Vol 8, No. 11, pp. 53—55.
`Arnihus et al. Liquidity, Asset Prices and Financial Policy.
`Financial Analysts Journal, vol. 47, No. 6, pp. 56—66.
`
`Actualidad Econornica: Free—For All In Electricity Sector?
`Dialog Article, p. 18, Sep. 30, 1996.
`
`Souter, Gavin. Berrnuda’s Reinsurers Eager to Please, Dia
`log Article, Business Insurance, vol. 28, No. 44, p. 77, Oct.
`31, 1994.
`
`Guardian, UK: Branch Closures Hit Poorer Custorners,
`Dialog Article, p. 18 Feb. 11, 1997.
`
`* cited by eXarniner
`
`Cisco Systems, Inc., EX 1152 Page 2
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 1 0f 23
`
`US 6,618,707 B1
`
`7
`
`5
`
`3
`
`Competetive
`Market Maker #1
`(CMM 1)
`
`Competetive
`Market Maker #2
`CMM 2
`(
`v
`)
`
`_
`pr'msgklgfrket
`(PMM)
`
`9
`
`1
`
`Electronic Access
`Member
`(EAM)
`
`Exchan G
`11 SE19
`
`13
`
`15
`
`12
`Third Party Connection
`Service Provider
`
`Customer
`(CUS)
`
`Customer
`(CUS)
`
`1 1
`
`Electronic Access
`Member
`(EAM)
`
`FIG. 1
`
`21
`
`Clearance
`Entity
`
`19
`
`Reporting
`Entity
`
`17
`
`Away Market
`
`18
`
`Market Maker on Away
`Market (FARMM)
`
`Cisco Systems, Inc., EX 1152 Page 3
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 2 0f 23
`
`US 6,618,707 B1
`
`Interface
`
`25
`
`Order Process
`
`23
`
`1
`
`[26
`S stern
`Mémory
`
`.
`
`33
`
`29
`
`Clearance and
`Reporting
`Process
`
`34
`Bid
`Matching
`Process
`
`39
`
`.
`Tick-worse
`Process
`
`28
`Away
`~— Market
`Process
`30
`
`FARMM
`Order
`Process
`
`35
`Block Order
`and
`Facilitation
`Process
`
`36
`Offer
`Matching
`Process
`
`38
`Step-up or
`Tick_down
`Process
`31
`Quote
`Matching
`Process
`37
`
`Fast Market
`Process
`
`32
`Derive or
`T d
`ra 6
`Process
`
`27
`
`'
`
`Book
`Memory
`
`40
`
`Opening
`Process
`
`Execute Trade
`Process
`
`FIG. 2
`
`Cisco Systems, Inc., EX 1152 Page 4
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 3 0f 23
`
`US 6,618,707 B1
`
`S5
`
`S11
`
`NO ———J
`
`Reject
`
`Yes
`
`'
`
`Reject
`
`I
`Yes
`
`| o d bl k
`S.
`1' er 0C or
`facilitation order?
`
`Yes
`
`Is there a
`Pas! Mam‘?
`
`“lo-p
`
`S1 3
`
`8m and
`Facilitalon
`Older
`Process
`
`Yes
`
`81 9
`
`817
`
`Is Order a
`FARMM Order?
`
`Y”
`
`Is there a
`Fast Market?
`
`"°"
`
`FARMM
`order
`Process
`
`NO
`
`Is there a
`Fast Market?
`
`ls Order buy
`or sell order?
`
`Yes l
`
`825
`
`Sell
`
`Fast
`Market
`Process
`
`FIG. 3(a)
`
`Cisco Systems, Inc., EX 1152 Page 5
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 4 0f 23
`
`US 6,618,707 B1
`
`S31(a)
`
`S31(b)
`
`N°__, Store in book
`memory '
`
`s35
`
`S31(c)
`
`S31(d)
`
`
`
`Bidpxzelcg?g 4_N° S36
`
`s37
`
`
`
`Yesa 331(9)
`
`S31 'f)
`
`Bid Matching ——No
`Process
`
`- there a betterp -:
`in my market?
`
`No—> Delete Order
`
`Yes
`
`l
`
`839
`
`Yes
`
`l
`
`831(9)
`
`Derive or
`
`FIG. 3(b)
`
`Cisco Systems, Inc., EX 1152 Page 6
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 5 0f 23
`
`US 6,618,707 B1
`
`S43(8)
`Does Order
`improve priee
`of lowest
`offer’?
`
`No '
`
`S43(b)
`Store in bOOk
`memory
`
`Yes
`
`Yes
`
`S47
`
`offer
`_
`Match'ng FNO
`Process
`
`s45
`ls Order a public
`customer order’?
`
`343(0)
`
`Yesq
`
`S43(d)
`Store in book
`memory
`
`ls Order size
`greater than
`minimum
`market size?
`
`Yes
`
`No
`
`Offer
`Matching
`Process
`
`—-—-N
`‘
`o
`
`Is there a
`better price
`i" away
`market?
`
`S49
`
`843(8)
`Is Order a public
`customer order?
`
`No >
`
`Delete Order
`
`(0
`
`Yes
`
`l
`
`851
`
`Away Market
`Process
`
`Yes
`
`l
`
`343(9)
`
`Din": 0'
`'3 6
`Process
`
`FIG. 3(c)
`
`Cisco Systems, Inc., EX 1152 Page 7
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 6 6f 23
`
`US 6,618,707 B1
`
`Market Order
`
`S1 02
`
`Reject Order <—No
`
`ls Order valid?
`
`Yes
`
`S106
`
`S104
`
`Is there a
`Fast Market 4—Ye$““ Fast Market?
`PFOOBSS
`
`Offer
`Matching
`Process
`
`<—seu
`
`Is the Order
`buy or sell
`orde?
`
`<———No
`
`No
`
`S108
`
`Is there a
`_
`b‘i?wxe
`market?
`
`Buy
`
`i
`
`8116
`
`Yes
`
`l
`
`e110
`
`Bid Matching
`Process
`
`Awséglleasgket
`
`FIG. 3(d)
`
`Cisco Systems, Inc., EX 1152 Page 8
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 7 0f 23
`
`US 6,618,707 B1
`
`8168
`Y?
`Trade Order again“ public
`manor order: In tine
`9mm!
`
`$110 No
`lathe Order
`?lbd In ful?
`
`Yes
`# S172
`
`Executa
`Trad:
`Process
`
`S158
`
`Trade Order
`against PMM
`quotation
`
`S160
`
`ls Order
`?lied in full?
`
`1
`
`S162
`
`Execuh
`Tmde
`
`FIG. 4(a)
`
`Cisco Systems, Inc., EX 1152 Page 9
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 8 0f 23
`
`US 6,618,707 B1
`
`S182
`
`Trade against
`professional
`No——> orders and
`quotations on a
`pro rata basis.
`
`'
`
`S184
`
`S186
`
`IlPWl-norly
`
`‘m.
`
`Y”
`
`-
`
`Tladasagamstmc
`
`I
`
`professtonal orders or
`quotations at the lows:
`
`No
`
`, Wish?“
`(SW’WSHPROD)
`
`Return
`
`FIG. 4(b)
`
`Cisco Systems, Inc., EX 1152 Page 10
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 9 0f 23
`
`US 6,618,707 B1
`
`Y“
`‘
`
`8216
`
`Trade Order against
`wblic untumr mien
`in "m0 M
`
`N,
`
`8206
`Trade Order against PMM
`m
`
`S208
`
`is Omar filed
`in M?
`
`821
`°
`
`Yes
`l
`
`Execute
`Trude
`Process
`
`‘L
`
`S214
`
`Execute
`Trade
`
`FIG. 5(a)
`
`Cisco Systems, Inc., EX 1152 Page 11
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 10 0f 23
`
`US 6,618,707 B1
`
`8222
`“MM
`“'mmh‘“
`Nd?
`
`8224
`
`Tlpde Orderagalnst
`No“, andquomionsona
`promabasie
`
`8228
`
`m3’?-
`W W?
`
`Trade the Order
`Yes—-> against the PM;
`queution.
`
`Yes"
`
`.SW
`
`7
`
`Return
`
`FIG. 5(b)
`
`Cisco Systems, Inc., EX 1152 Page 12
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 11 0f 23
`
`US 6,618,707 B1
`
`Tic-Worse
`Process
`
`Retrieve tit/worse value
`
`S302
`
`V
`
`Delete quotation from book
`memory
`
`$303
`
`Enter new quotation based
`on tick worse value
`
`S305
`
`FIG. 6
`
`Cisco Systems, Inc., EX 1152 Page 13
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 12 0f 23
`
`US 6,618,707 B1
`
`Step-up or "?ck
`worse process
`
`Retrive step-up
`parameter 2
`
`$312
`
`7
`
`Compute Q. the
`difference between
`minimum market
`size and size of
`quotation
`
`S316
`
`S314
`N O
`
`Trek-worse
`Process
`
`Yes
`¢
`
`8318
`
`Increase size of
`quotation by Q
`
`8320
`
`V
`
`Decrease Z by Q
`
`S322
`
`Store new value
`for Z
`
`FIG. 7
`
`Return
`
`Cisco Systems, Inc., EX 1152 Page 14
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 13 0f 23
`
`US 6,618,707 B1
`
`Derive or
`Trade
`Process
`
`Determine Y
`
`Is the difference
`between X and the total
`
`Trade the order
`Yes———-> against PMM
`
`S335
`
`Derive order with size
`equal to the difference
`between X and the
`order size.
`
`8339
`
`FIG. 8
`
`Cisco Systems, Inc., EX 1152 Page 15
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 14 0f 23
`
`US 6,618,707 B1
`
`Away Market
`Process
`
`Determine the price
`difference between
`the PMM‘s quote and
`the away market
`price.
`
`‘ S342
`
`Retrieve PMM's
`away market
`matching table.
`
`is the Order size less
`.
`than the maxlmum volume at
`the price differential?
`
`No————————>
`
`S346
`
`Store hidden
`Order In book
`d lert
`memory a" a
`the PMM
`
`Yes
`l 8348
`Trade the Order
`with the PMM at
`the away market
`price.
`
`$350
`
`FIG. 9
`
`Cisco Systems, Inc., EX 1152 Page 16
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 15 0f 23
`
`US 6,618,707 B1
`
`Fast Market
`Process
`
`Select the best bid
`as the current bid
`
`S569
`
`Calculate the number
`of contracts that will
`trade and store
`volume and price in
`system memory
`
`the current bid equal t
`the PMM's bid?
`
`I
`
`S573
`
`Select next lower bid
`as the current bid
`
`FIG. 10(a)
`
`Cisco Systems, Inc., EX 1152 Page 17
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 16 0f 23
`
`US 6,618,707 B1
`
`S577
`
`Select the best offer
`as the current offer
`
`S578
`
`Calculate the number
`of oontrads that will
`trade and store
`volume and price in
`system memory
`
`s the current offer equa
`to the PMM‘s bid?
`
`Yes
`
`l
`
`8580
`
`Select next worse
`offer as the current
`Offer
`
`FIG. 10(b)
`
`Cisco Systems, Inc., EX 1152 Page 18
`
`

`

`U.S. Patent
`
`Sep. 9,2003
`
`Sheet 17 0f 23
`
`US 6,618,707 B1
`
`8587
`
`Yes
`
`Trade all orders
`atlheprice
`
`I
`
`S591
`
`Yes -————->
`
`Trade orders at
`the average of
`the two prices
`found in $585
`
`Return
`
`——> Is it a call?
`
`3599
`
`8597
`
`Trade at higher
`of prices from
`Yes+
`$585
`
`l
`
`8595
`
`Set N=(number
`of ticks in the
`spread) -2
`
`No
`
`S600
`
`Trade a! lower
`price from 8585
`
`FIG. 10(c)
`
`Cisco Systems, Inc., EX 1152 Page 19
`
`

`

`U.S. Patent
`
`Sep. 9, 2003
`
`Sheet 18 0f 23
`
`US 6,618,707 B1
`
`$602
`
`$606
`
`Trade at higher
`Yes-—> price fmm S585
`minus N ticks
`
`No
`
`1
`
`8604
`
`Trade at lower
`price from $585
`plus N ticks
`
`FIG. 10(d)
`
`Cisco Systems, Inc., EX 1152 Page 20
`
`

`

`US. Patent
`
`Sep. 9, 2003
`
`Sheet 19 0f 23
`
`US 6,618,707 B1
`
`Store terms of block
`order
`
`Identify PMM and
`CMMs assigned to
`class and professional
`orders at the best bid or
`best offer
`
`Send message
`
`Receive and
`store responses
`for M seconds
`
`
`
`..
`
`’ Facmlatron
`
`.
`
`ls order block or
`
`facilitation?
`
`Block———>©
`
`FIG. 11(a)
`
`Cisco Systems, Inc., EX 1152 Page 21
`
`Cisco Systems, Inc., EX 1152 Page 21
`
`

`

`US. Patent
`
`Sep. 9, 2003
`
`Sheet 20 0f 23
`
`US 6,618,707 B1
`
`3669
`
`
`
`Execute responses
`and Orders and
`quotations” that are at
`a price higher than
`the execution price
`
`
`
`
`
`
`
`
`Delete order
`and responses
`
`
`Determine buy
`order execution
`
`price
`Execute public
`
`customer orders
`at the execution
`
`
`
`$665
`
`price
`
`Execute responses
`
`
`and orders and
`quotations that are at
`
`
`a price lower than
`
`the execution price
`Apply allocation
`algofithm
`
`
`
`S666
`
`Execute public.
`
`
`customer orders
`
`at the execution
`
`
`price
`8667
`
`
`
`
`I
`
`Apply allocation
`
`algorithm
`
`FIG. 11(b)
`
`Cisco Systems, Inc., EX 1152 Page 22
`
`Cisco Systems, Inc., EX 1152 Page 22
`
`

`

`US. Patent
`
`Sep. 9, 2003
`
`Sheet 21 0f 23
`
`US 6,618,707 B1
`
`
`
`Execute responses
`and orders and
`quotations that are at
`a price tower than the
`execufion price
`
`
`
`
`
`
`Apply altocation
`algorithm
`
`
`
`_ Execute any
`unexecuted
`balance against
`EAM
`
`8686
`
`8685
`
`Exewte public
`
`
`
`customer orders
`at the execution
`price
`
`
`
`Attempt to execute
`defined
`percentage
`against EAM '
`!
`
`
`
`8687
`
`8695
`
`Apply allocation
`algorithm
`
`Execute any
`unexecuted
`balance against
`EAM
`
`FIG. 11(c)
`
`Cisco Systems, Inc., EX 1152 Page 23
`
`Cisco Systems, Inc., EX 1152 Page 23
`
`

`

`US. Patent
`
`Sep. 9, 2003
`
`Sheet 22 0f 23
`
`US 6,618,707 B1
`
`8610
`
`Yes
`
`'
`7
`Are alt senes open-
`
`
`
`}
`
`Status is trying
`to open for a“
`series not open
`
`
`
`
`
`
`
`8616
`
`Opening
`comp'ete
`
`FIG. 12
`
`Cisco Systems, Inc., EX 1152 Page 24
`
`Cisco Systems, Inc., EX 1152 Page 24
`
`

`

`US. Patent
`
`Sep. 9, 2003
`
`Sheet23 0f23
`
`US 6,618,707 B1
`
`
`Bid quotation
`matching ask
`
`
`quotation
`
`
`
`
`
`Mark the matching
`bid quotation and
`ask quotation
`
`
`
`Are there any
`
`matching bid
`
`quotations and ask
`quotations?
`
`
`S708
`
`No
`
`Delete any marks
`
`
` Mark any
`
`
`
`
`
`matching bid
`quotations and ask
`quotations
`
`
`
` Trade any
`matching bid
`
`quotations and ask
`
`quotations that
`have at least two
`
`
`marks
`
`
`FIG. 13
`
`Cisco Systems, Inc., EX 1152 Page 25
`
`Cisco Systems, Inc., EX 1152 Page 25
`
`

`

`US 6,618,707 B1
`
`1
`AUTOMATED EXCHANGE FOR TRADING
`DERIVATIVE SECURITIES
`
`RELATED APPLICATIONS
`
`The present invention is disclosed in a provisional appli-
`cation filed under 35 U.S.C.§111(b), US. Application No.
`60/106,935, filed Nov. 3, 1998. Priority is hereby claimed
`under 35 U.S.C.§119(e) for that earlier filed provisional
`application.
`
`FIELD OF THE INVENTION
`
`This invention relates generally to markets for the
`exchange of securities, and more particularly to an auto-
`mated exchange for the trading of options contracts, that
`equitably allocates trades among market professionals and
`assures liquidity.
`
`BACKGROUND OF THE INVENTION
`
`The options market first developed in the 1970s. Since
`that time, options for the purchase and sale of listed stocks
`have traded domestically only on floor-based exchanges, for
`example,
`the American Stock Exchange
`The
`method of trading options contracts in these floor-based
`environments is known as an “open outcry” system because
`trading takes place through oral communications between
`market professionals at a central location in open view of
`other market professionals.
`In this system, an order is
`typically relayed out to a trader standing in a “pit.” The
`trader shouts out that he has received an order and waits until
`
`another trader or traders shouts back a two-sided market (the
`prices at which they are willing to buy and sell a particular
`option contract), then a trade results. In an effort to preserve
`this antiquated system of floor-based trading, the transition
`to and use of computer-based technology on these
`exchanges has been slow. Although some processes that take
`place on these floor-based exchanges have been automated
`or partially automated, they are not fully integrated and, in
`fact, many processes continue to function manually. As a
`result, there are many problems with the existing floor-based
`system that have caused large inefficiencies and inadequa-
`cies in order handling and price competition in the options
`market, and have harbored potential for abuse and mistakes.
`By way of background, several of the floor-based markets
`rely on the skills of market professionals, known as
`specialists, who are responsible for maintaining an orderly
`market and providing liquidity. Specialists accept orders,
`establish prices for a particular series of options and allocate
`trades among market professionals. In return for accepting
`these responsibilities, specialists oftentimes are assured
`minimum participation rights in the trading activity that
`occurs in the pit. As is discussed below, this participation
`right is not exercised over the smaller-size public customer
`market orders that trade with the single display systems.
`Instead, it is up to a specialist to claim the minimum amount
`of trading through the orders that are routed into the pit for
`trade-by-trade execution.
`Specialists are part of a larger class of market
`professionals, known as market makers, who like specialists,
`are responsible for maintaining liquidity in the market.
`Market makers fulfill this responsibility by ensuring that
`there is always a two-sided market through calling out prices
`(quotations) at which they are both willing to buy (bid) and
`sell (offer) a particular option contract and honoring those
`quotations when trading with incoming orders. In the tradi-
`tional open outcry system, market makers call out these
`
`2
`quotations each time an order is routed into the trading pit.
`Over time, each of the existing options exchanges has
`developed systems to track the best quotation. What gener-
`ally happens is that market makers call out quotations which
`are manually entered into a system that tracks and displays
`the single best bid and best offer for the entire trading pit at
`any given time. As the market makers continue to call out
`new quotations, the system is updated to reflect the current
`best bid and best offer. In their existing state, these quotation
`systems do not track or identify which market maker called
`out the quote currently displayed or the number of contracts
`(size) for which the market maker is willing to honor at that
`quotation. As is discussed below,
`these systems simply
`display a single quotation for the entire pit that is generally
`understood to be valid (firm) for only smaller-sized orders,
`for example 10 contracts, and for only certain types of
`orders, for example public customer orders entered on an
`exchange for immediate execution at the existing market
`price (the best bid or offer) known as “market orders.” The
`floor-based exchanges generally have procedures for the
`automatic execution and allocation of these smaller-sized
`
`public customer market orders at the displayed quotations
`through a rotation assignment of the orders among the pit
`market makers.
`
`Execution through use of the displayed quotation and
`automatic allocation to market makers does provide a guar-
`anteed market for incoming smaller-sized public customer
`market orders. However, this system does not provide an
`incentive for members to make quotations for size larger
`than the minimum,
`i.e., 10 contracts from the above
`example. In fact, often these automatic allocation systems do
`not permit market makers to make quotations for larger size.
`Further, because the bid and offer prices for these allocation
`systems are set by a single quotation, the existing best bid
`and best offer may not always accurately reflect the desire of
`each and every market maker, which makes it difficult for
`market makers to change the quotation to reflect changes in
`the market. If the market for the option becomes volatile, for
`example, when the price of the underlying stock fluctuates
`or if a market maker simply changes his opinion on what a
`fair price for that option should be, market makers risk being
`forced to trade at a disadvantageous price displayed on the
`single quotation system.
`the
`trade at
`On the other hand, market makers must
`displayed market price or else update the quoted price if they
`wish to improve the market. However, members have no
`incentive to quote a price that improves the market, i.e.
`quote a higher bid or lower offer than the current displayed
`market price, because these systems allocate public cus-
`tomer market orders to market makers in turn through a
`rotation process. Therefore,
`to what extent an individual
`market maker is allowed to participate in a particular order
`is a matter of chance and whether a market maker who
`
`10
`
`15
`
`20
`
`25
`
`30
`
`35
`
`40
`
`45
`
`50
`
`55
`
`quotes a better market is able capture the benefit of his
`quotation in a particular option series depends upon his
`location in the allocation rotation.
`
`60
`
`The ability for a market maker to act independently and
`to make deep liquid markets is severely inhibited by these
`single quotation allocation systems. The inherent inadequa-
`cies in these single quotation systems stem from the fact that
`individual market makers’ quotations and size are not
`tracked or identified. As well the size that market makers are
`
`willing to trade at the next best prices (prices lower than the
`best displayed bid or higher than the best displayed offer) is
`not tracked or identified. These deficiencies make it difficult
`
`65
`
`to assess market depth and liquidity and ultimately impact
`that quality of the prices customers receive for their orders.
`
`Cisco Systems, Inc., EX 1152 Page 26
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`Cisco Systems, Inc., EX 1152 Page 26
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`

`

`US 6,618,707 B1
`
`3
`What is more, because no record of market quotations exists
`beyond the single quotation system it is virtually impossible
`to accurately recreate and document historical market con-
`ditions.
`
`As discussed above, these existing single quotation sys-
`tems generally provide a guaranteed market at the currently
`displayed best bid or best offer only for incoming smaller-
`sized public customer market orders. The execution and
`allocation procedures, however, are not honored for orders
`not meeting this criteria. Instead, non-marketable orders
`where a particular price is bid or offered (limit orders),
`orders above the minimum size, and orders placed by
`professionals (professional orders), for example, broker-
`dealers trading for firm accounts and market makers trading
`from other options exchanges, frequently continue to be
`quoted on a case-by-case basis by the market makers in the
`pit. These orders, therefore, do not even receive the benefit
`of the single quote allocation systems, which despite their
`shortcomings, at
`least afford an opportunity for quicker
`execution at guaranteed prices. In addition, in periods of
`high volatility or order volume, or similar circumstances in
`the trading of the underlying security, a procedure known as
`a fast market may be instituted. When a fast market exists,
`the displayed quotations are not honored and market pro-
`fessionals generally revert to quoting incoming orders one
`series at a time until the condition ultimately subsides.
`When a limit order cannot be filled immediately either
`because the price bid or offered is outside the market or
`because there is inadequate size to fill
`the order at
`the
`volume ordered, the order is placed on a “book.” A book,
`more accurately a limit book, is a record of outstanding
`public customer limit orders that can be matched against
`future incoming orders. Professional orders are usually not
`allowed on the limit book. At
`the existing options
`exchanges, these limit books may be maintained in a manual
`and/or electronic format. The current systems, however,
`generally are not integrated with the single quotation sys-
`tems. Because the systems stand apart, the best bid and best
`offer for quotations is calculated separately from the best bid
`and best offer for the limit book. Moreover, professional
`orders are not generally accounted for in either of these two
`calculations. As a result, in instances where the limit book
`matches or betters a displayed quotation, incoming market
`orders are not traded automatically. In those cases, incoming
`smaller-size customer market orders utilizing a display
`quotation system instead must be “kicked out” and
`announced to the trading pit in open outcry or manually
`executed against the limit book.
`Broadcast of orders on the floor on a case-by-case basis
`can create a disadvantage for parties wishing to place larger
`orders. First, trading is not anonymous. Therefore, market
`makers in the trading pit are able to determine to some extent
`the identity of the party placing the order and, as a result,
`oftentimes condition what they are willing to quote on, for
`example, whether the order is from a public customer or a
`market professional. Second, the fact that an order for a
`larger number of options contracts has been placed can have
`an effect on the price of the underlying stock. Persons
`overhearing the order placed on the floor market can “trade
`ahead”, that is, buy or sell the underlying stock in anticipa-
`tion of the owner of the options contracts exercising its
`options. Trading ahead violates market rules, however,
`because a large number of people are aware of orders placed
`on floor markets, effective policing of parties that
`trade
`ahead is impractical.
`Under the current infrastructure, there is little account-
`ability amongst
`the individual market makers to make
`
`10
`
`15
`
`20
`
`25
`
`30
`
`35
`
`40
`
`45
`
`50
`
`55
`
`60
`
`65
`
`4
`two-sided markets with size and continuously call out quo-
`tations. The single quote display systems, on the one hand,
`looks to the crowd and not
`individuals to maintain the
`
`quotations. The traditional open outcry process, on the other
`hand, provides market makers with the opportunity to react
`to whichever orders they want to respond and to determine
`how they want to respond. For example, with incoming
`orders not routed through the single quote display systems,
`market makers often distinguish between public customer
`and professional orders and vary the quotations they are
`willing to trade at after learning of the order type, not before.
`What is more, market makers do not quote size for which
`they are willing to trade at the next best prices (lower than
`the best bid and higher than the best offer) or make distinc-
`tions on what they are willing to trade with other market
`professionals at the next best prices.
`to each option
`Beyond the trading processes internal
`exchange, additional considerations arise when an option is
`listed on multiple exchanges. In order to assure that an order
`in a multiply-listed contract receives the best execution
`price, market professionals are charged with the responsi-
`bility of checking the other exchanges’ quotations for prices
`better that the exchange’s best bid or best offer and with the
`responsibility of contacting the other exchange to verify that
`the quotations are valid. If better quotation exists at another
`exchange, that exchange’s market participants must either
`trade at
`that price or change (fade) the quotation. The
`incoming order is generally not automatically processed and
`must addressed on a case-by-case basis. This entire process
`of checking other exchange quotations is dependent upon
`the originating exchange market professionals” personal
`efforts to verify the other markets’ quotations each time an
`order comes into the trading pit.
`The increasing volume of trades in options contracts, as
`well as the speed at which price information of underlying
`stocks is transmitted to consumers, has increased the
`demand for faster trade execution in today’s market. In
`addition, volatility in the price of underlying stocks that are
`the basis for options contracts place further pressure on
`exchanges to execute trades quickly and at an equitable
`price. Market makers on floor-based markets are limited in
`the speed at which they can react to market fluctuations and
`respond with quotations. This limited response speed leads
`to greater market volatility and lower liquidity because the
`market makers are less willing to risk trading large numbers
`of contracts where the price may not be optimal. The
`disjointed nature of the various manual, and sometimes
`automated, systems which take place on floor-based
`exchanges cultivate these deficiencies and, again, make it
`difficult to assess the true market depth and liquidity and
`ultimately impact that quality of the prices.
`
`SUMMARY OF THE INVENTION
`
`It is an advantage of the invention to provide an auto-
`mated system for matching previously entered orders and
`quotations with incoming orders and quotations on an
`exchange for securities, which will improve liquidity and
`assure the fair handling of orders.
`It is a further advantage of the invention to provide an
`automated exchange for securities wherein an incoming
`order is filled first against public customer orders and then
`filled against professional orders and quotations on a pro rata
`basis based on the size of the professional order or quotation.
`It is yet another advantage of the invention to provide an
`automated exchange for the trading of securities wherein a
`primary market maker also known as a specialist is given a
`
`Cisco Systems, Inc., EX 1152 Page 27
`
`Cisco Systems, Inc., EX 1152 Page 27
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`

`

`US 6,618,707 B1
`
`5
`relatively higher portion of the pro rata order volume,
`primary market maker being a market maker with additional
`responsibilities toward maintaining an orderly market.
`It is yet another advantage of the invention to provide an
`exchange that automatically moves the price of a market
`maker’s quotation one or more trading increments worse
`that the quotation price after the size of the quotation has
`been exhausted, such new quotation having a predetermined
`size that is dependent upon the price of the new quotation.
`It is yet another advantage of the invention to provide an
`exchange that automatically guarantees a predetermined
`minimum number of contracts at the market price by placing
`a derived order for a primary market maker at the market
`price so that the total size at that price will be at least the
`predetermined minimum number of contracts.
`It is another advantage of the invention to provide an
`automated exchange for securities that employs an auto-
`mated away market process to assure that orders eligible for
`away market protection are executed at prices better than or
`equal to away market prices.
`It is another advantage of the invention to provide an
`automated exchange for securities that employs an auto-
`mated fast market process to reduce volatility in the market
`and assure that orders are executed at fair prices.
`It is another advantage of the invention to provide an
`automated exchange for securities that employs an auto-
`mated opening process to assure that orders entered on an
`opening are executed at a fair price and that opening
`quotations accurately reflect the market interests.
`It is yet another advantage of the invention to provide an
`automated exchange for securities that employs a block
`order process to assure that larger-sized orders are executed
`at a fair price.
`It is another advantage of the invention to provide an
`automated exchange for securities. that employs a facilita-
`tion process to assure that larger-sized orders are executed at
`a fair price while guaranteeing that a minimum percentage
`of a larger-sized order is traded by the market professional
`who entered the larger-sized order, after any public customer
`orders at the best price or prices are executed.
`It is another advantage of the invention to provide a
`quotation matching process whereby bid quotation and ask
`quotations are not
`immediately executed to provide an
`opportunity for automatic quotations system to adjust their
`prices before trading with a quotation generated by a faster
`automatic quotation system.
`It i