[Federal Register Volume 76, Number 41 (Wednesday, March 2, 2011)]
[Notices]
[Pages 11533-11541]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-4574]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-63955; File No. SR-ISE-2010-73]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Order Granting Approval of a Proposed Rule Change To Modify
Qualified Contingent Cross Order Rules
February 24, 2011.
I. Introduction
On July 14, 2010, the International Securities Exchange, LLC
(``ISE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to modify rules for Qualified
Contingent Cross (``QCC'') Orders. The proposed rule change was
published for comment in the Federal Register on July 23, 2010.\3\ The
Commission received eight comment letters on the proposed rule change
\4\ and a response letter from ISE.\5\
[[Page 11534]]
This order approves the proposed rule change.
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 62523 (July 16,
2010), 75 FR 43211 (``Notice'').
\4\ See Letters from Anthony J. Saliba, Chief Executive Officer,
LiquidPoint, LLC, to Elizabeth M. Murphy, Secretary, Commission
dated, July 30, 2010 (``LiquidPoint Letter 2''); William J. Brodsky,
Chairman and Chief Executive Officer, Chicago Board Options
Exchange, Incorporated (``CBOE''), to Elizabeth M. Murphy,
Secretary, Commission, dated August 9, 2010 (``CBOE Letter 1''); Ben
Londergan and John Gilmartin, Co-Chief Executive Officers, Group One
Trading, LP, to Elizabeth M. Murphy, Secretary, Commission, dated
August 9, 2010 (``Group One Letter 2''); Janet M. Kissane, Senior
Vice President--Legal and Corporate Secretary, NYSE Euronext, to
Elizabeth M. Murphy, Secretary, Commission, dated August 9, 2010
(``NYSE Letter 2''); Thomas Wittman, President, NASDAQ OMX PHLX,
Inc. (``Phlx''), to Elizabeth M. Murphy, Secretary, Commission,
dated August 13, 2010 (``Phlx Letter 2''); J. Micah Glick, Chief
Compliance Officer, Cutler Group LP to Elizabeth M. Murphy,
Secretary, Commission, dated September 3, 2010 (``Cutler Letter'');
Janet L. McGinness, Senior Vice President--Legal and Corporate
Secretary, NYSE Euronext, to Elizabeth M. Murphy, Secretary,
Commission, dated October 21, 2010 (``NYSE Letter 3''); and Gerald
D. O'Connell, Chief Compliance Officer, Susquehanna International
Group, LLP, to Elizabeth M. Murphy, Secretary, Commission, dated
October 22, 2010 (``Susquehanna Letter 2'').
\5\ See Letter from Michael J. Simon, Secretary and General
Counsel, ISE, to Elizabeth M. Murphy, Secretary, Commission, dated,
August 25, 2010 (``ISE Response'').
---------------------------------------------------------------------------
II. Background
A. Regulation NMS and Qualified Contingent Trades
The Commission adopted Regulation NMS in June 2005.\6\ Among other
things, Regulation NMS addressed intermarket trade-throughs of
quotations in NMS stocks.\7\ In 2006, pursuant to Rule 611(d) of
Regulation NMS,\8\ the Commission provided an exemption \9\ for each
NMS stock component of certain qualified contingent trades (as defined
below) from Rule 611(a) of Regulation NMS for any trade-throughs caused
by the execution of an order involving one or more NMS stocks (each an
``Exempted NMS Stock Transaction'') that are components of a qualified
contingent trade.
---------------------------------------------------------------------------
\6\ See Securities Exchange Act Release No. 51808 (June 9,
2005), 70 FR 37496 (June 29, 2005).
\7\ See 17 CFR 242.611. An ``NMS stock'' means any security or
class of securities, other than an option, for which transaction
reports are collected, processed, and made available pursuant to an
effective transaction reporting plan. See 17 CFR 242.600(b)(46) and
(47).
\8\ 17 CFR 242.611(d). See also 15 U.S.C. 78mm(a)(1) (providing
general authority for the Commission to grant exemptions from
provisions of the Act and the rules thereunder).
\9\ See Securities Exchange Act Release No. 54389 (August 31,
2006), 71 FR 52829 (September 7, 2006) (``Original QCT Exemption'').
The Securities Industry Association (``SIA,'' n/k/a Securities
Industry and Financial Markets Association) requested the exemption.
See Letter to Nancy M. Morris, Secretary, Commission, from Andrew
Madoff, SIA Trading Committee, SIA, dated June 21, 2006.
---------------------------------------------------------------------------
The Original QCT Exemption defined a ``qualified contingent trade''
to be a transaction consisting of two or more component orders,
executed as agent or principal, where: (1) At least one component is in
an NMS stock; (2) all components are effected with a product or price
contingency that either has been agreed to by the respective
counterparties or arranged for by a broker-dealer as principal or
agent; (3) the execution of one component is contingent upon the
execution of all other components at or near the same time; (4) the
specific relationship between the component orders (e.g., the spread
between the prices of the component orders) is determined at the time
the contingent order is placed; (5) the component orders bear a
derivative relationship to one another, represent different classes of
shares of the same issuer, or involve the securities of participants in
mergers or with intentions to merge that have been announced or since
cancelled; \10\ (6) the Exempted NMS Stock Transaction is fully hedged
(without regard to any prior existing position) as a result of the
other components of the contingent trade; \11\ and (7) the Exempted NMS
Stock Transaction that is part of a contingent trade involves at least
10,000 shares or has a market value of at least $200,000.\12\
---------------------------------------------------------------------------
\10\ Transactions involving securities of participants in
mergers or with intentions to merge that have been announced would
meet this aspect of the requested exemption. Transactions involving
cancelled mergers, however, would constitute qualified contingent
trades only to the extent they involve the unwinding of a pre-
existing position in the merger participants' shares. Statistical
arbitrage transactions, absent some other derivative or merger
arbitrage relationship between component orders, would not satisfy
this element of the definition of a qualified contingent trade. See
Original QCT Exemption, supra, note 9.
\11\ A trading center may demonstrate that an Exempted NMS Stock
Transaction is fully hedged under the circumstances based on the use
of reasonable risk-valuation methodologies. Id.
\12\ See 17 CFR 242.600(b)(9) (defining ``block size'' with
respect to an order as at least 10,000 shares or $200,000 in market
value).
---------------------------------------------------------------------------
In 2008, in response to a request from the CBOE, the Commission
modified the Original QCT Exemption to remove the ``block size''
requirement of the exemption (i.e., that the Exempted NMS Stock
Transaction be part of a contingent trade involving at least 10,000
shares or having a market value of at least $200,000).\13\
---------------------------------------------------------------------------
\13\ See Securities Exchange Act Release No. 57620 (April 4,
2008) 73 FR 19271 (April 9, 2008) (``CBOE QCT Exemption''). The
current QCT Exemption (i.e., as modified by the CBOE QCT Exemption)
is referred to herein as the ``NMS QCT Exemption.''
---------------------------------------------------------------------------
B. Background of ISE's Proposal
In August 2009, the Commission approved the Order Protection and
Locked/Crossed Market Plan \14\ which, among other things, required the
options exchanges to adopt written policies and procedures reasonably
designed to prevent trade-throughs.\15\ Unlike its predecessor
plan,\16\ the New Linkage Plan does not include a trade-through
exemption for ``Block Trades,'' defined to be trades of 500 or more
contracts with a premium value of at least $150,000.\17\ However,
because the New Linkage Plan does not provide a Block Trade exemption,
the Exchange was concerned that the loss of the Block Trade exemption
would adversely affect the ability of its members to effect large
trades that are tied to stock. Accordingly, the Exchange proposed the
Original QCC Order (defined below) as a limited substitute for the
Block Trade exemption to facilitate the execution of large stock/option
combination orders, to be implemented contemporaneously with the New
Linkage Rules.
---------------------------------------------------------------------------
\14\ See Securities Exchange Act Release No. 60405 (July 30,
2009), 74 FR 39362 (August 6, 2009) (File No. 4-546) (``New Linkage
Plan''). ISE also proposed revisions to its rules to implement the
New Linkage Plan (``New Linkage Rules''). See Securities Exchange
Act Release No. 60559 (August 21, 2009), 74 FR 44425 (August 28,
2009) (SR-ISE-2009-27).
\15\ A trade-through is a transaction in a given option series
at a price that is inferior to the best price available in the
market.
\16\ The former options linkage plan, the Plan for the Purpose
of Creating and Operating an Intermarket Option Linkage (``Former
Linkage Plan''), was approved by the Commission in 2000 and was
operative until August 31, 2009, when the New Linkage Plan took
effect. See Securities Exchange Act Release No. 43086 (July 28,
2000), 65 FR 48023 (August 4, 2000) (File No. 4-429).
\17\ See Sections 2(3) and 8(c)(i)(C) of the Former Linkage Plan
and old ISE Rule 1902(d)(2).
---------------------------------------------------------------------------
C. SR-ISE-2009-35
1. ISE's Original Qualified Contingent Cross Order Proposal
In SR-ISE-2009-35,\18\ ISE proposed a new order type, the QCC
Order. The QCC Order as proposed in SR-ISE-2009-35 (``Original QCC
Order'') permitted an ISE member to cross the options leg of a
Qualified Contingent Trade (``QCT'') (as defined below) on ISE
immediately upon entry, without exposure, if the order: (i) Was for at
least 500 contracts; (ii) met the six requirements of the NMS QCT
Exemption; and (iii) was executed at a price at or between the national
best bid or offer (``NBBO''). Proposed Supplementary Material .01 to
ISE Rule 715 defined a QCT as a transaction composed of two or more
orders, executed as agent or principal, where: (i) At least one
component is in an NMS stock; (ii) all components are effected with a
product or price contingency that either has been agreed to by all the
respective counterparties or arranged for by a broker-dealer as
principal or agent; (iii) the execution of one component is contingent
upon the execution of all other components at or near the same time;
(iv) the specific relationship between the component orders (e.g., the
spread between the prices of the component orders) is determined by the
time the contingent order is placed; (v) the component orders bear a
derivative relationship to one another, represent different classes of
shares of the same issuer, or involve the securities of participants in
mergers or with intentions to merge that have been announced or
cancelled; and (vi) the transaction is fully hedged (without regard to
any prior existing position) as a result of other components of the
contingent trade.\19\
---------------------------------------------------------------------------
\18\ See Securities Exchange Act Release No. 60147 (June 19,
2009), 74 FR 30651 (June 26, 2009) (SR-ISE-2009-35 Notice).
\19\ The six requirements are substantively identical to the six
elements of a QCT under the NMS QCT Exemption. See supra notes 9 and
13.
---------------------------------------------------------------------------
On August 28, 2009, the Commission approved, by authority delegated
to the
[[Page 11535]]
Division of Trading and Markets, ISE's Original QCC Order proposal.\20\
On September 4, 2009, CBOE filed with the Commission a notice of
intention to file a petition for review of the Commission's approval by
delegated authority \21\ and, on September 14, 2009, CBOE filed a
petition for review, which automatically stayed the delegated approval
of the Original QCC Order.\22\ On September 11, 2009, ISE filed a
motion to lift the automatic stay.\23\ On September 17, 2009, CBOE
filed a response to ISE's Motion.\24\ On September 22, 2009, ISE filed
a reply in support of its motion to lift the automatic stay.\25\ In
addition to the submissions from CBOE and ISE, the Commission received
eight comment letters requesting that the Commission grant CBOE's
Petition for Review.\26\
---------------------------------------------------------------------------
\20\ See Securities Exchange Act Release No. 60584 (August 28,
2009), 74 FR 45663 (September 3, 2009) (``Original Approval
Order'').
\21\ See Letter from Paul E. Dengel, Counsel for CBOE, Schiff
Hardin LLP, to Elizabeth M. Murphy, Secretary, Commission, dated
September 4, 2009.
\22\ See Letter from Joanne Moffic-Silver, General Counsel and
Corporate Secretary, CBOE, to Elizabeth M. Murphy, Secretary,
Commission, dated September 14, 2009 (``Petition for Review'').
\23\ See Brief in Support of ISE's Motion to Lift the Commission
Rule 431(e) Automatic Stay of Delegated Action Triggered by CBOE's
Notice of Intention to Petition for Review, dated September 11, 2009
(``ISE's Motion'').
\24\ See Response of CBOE to Motion of ISE to Lift Automatic
Stay, dated September 17, 2009 (``Response to Motion'').
\25\ See Reply in Support of ISE's Motion to Lift the Commission
Rule 431(e) Automatic Stay of Delegated Action Triggered by CBOE's
Notice of Intention to Petition for Review, dated September 22, 2009
(``ISE Reply'').
\26\ See Letters from Jeffrey S. Davis, Vice President and
Deputy General Counsel, NASDAQ OMX PHLX, Inc., to Elizabeth M.
Murphy, Secretary, Commission, dated September 22, 2009 (``Phlx
Letter''); Gerald D. O'Connell, Chief Compliance Officer,
Susquehanna International Group, LLP, to Elizabeth M. Murphy,
Secretary, Commission, dated September 30, 2009 (``Susquehanna
Letter''); Megan A. Flaherty, Chief Legal Counsel, Wolverine
Trading, LLC, to Elizabeth M. Murphy, Secretary, Commission, dated
October 2, 2009 (``Wolverine Letter''); Janet M. Kissane, Senior
Vice President--Legal and Corporate Secretary, NYSE Euronext, to
Elizabeth M. Murphy, Secretary, Commission, dated October 5, 2009
(``NYSE Letter''); Ben Londergan, Co-CEO, Group One Trading, L.P.,
to Elizabeth M. Murphy, Secretary, Commission, dated October 5, 2009
(``Group One Letter''); Anthony J. Saliba, Chief Executive Officer,
LiquidPoint, LLC, to Elizabeth M. Murphy, Secretary, Commission,
dated October 7, 2009 (``LiquidPoint Letter''); Kimberly Unger,
Executive Director, The Security Traders Association of New York,
Inc., to Elizabeth M. Murphy, Secretary, Commission, dated October
29, 2009 (``STA Letter''); and Peter Schwarz, Integral Derivatives,
LLC, to Elizabeth M. Murphy, Secretary, Commission, dated November
25, 2009 (``Integral Derivatives Letter''). In addition, ISE
submitted certain market volume and share statistics. See E-mail
from Michael J. Simon, ISE, to Elizabeth King, Associate Director,
Division of Trading and Markets, Commission, dated September 30,
2009.
---------------------------------------------------------------------------
On November 12, 2009, the Commission granted CBOE's Petition for
Review and denied ISE's motion to lift the automatic stay.\27\ In
connection with the Order Granting Petition, the Commission received
three statements in support of the Original Approval Order (two of
which were submitted by ISE) \28\ and five statements in opposition to
the Original Approval Order (two of which were submitted by CBOE).\29\
---------------------------------------------------------------------------
\27\ See Commission Order Granting Petition for Review and
Scheduling Filing of Statements, dated November 12, 2009 and
Commission Order Denying ISE's Motion to Lift the Commission Rule
431(e) Automatic Stay of Delegate Action Triggered by CBOE's Notice
of Intention to Petition for Review, dated November 12, 2009
(``Order Granting Petition'').
\28\ See Letters from Michael J. Simon, Secretary, ISE, to
Elizabeth M. Murphy, Secretary, Commission, dated December 3, 2009
(``ISE Statement 1''); from Leonard Ellis, Head of Capital Markets,
Capstone Global Markets, LLC, to Elizabeth Murphy, Secretary,
Commission, dated December 3, 2009 (``Capstone Statement''); and
Michael J. Simon, Secretary, ISE, to Elizabeth M. Murphy, Secretary,
Commission, dated December 16, 2009 (``ISE Statement 2'').
\29\ See Letters from Joanne Moffic-Silver, Executive Vice
President, General Counsel & Corporate Secretary, CBOE, to Elizabeth
M. Murphy, Secretary, Commission, dated December 3, 2009 (``CBOE
Statement 1''); Michael Goodwin, Senior Managing Member, Bluefin
Trading, LLC, to Elizabeth M. Murphy, Secretary, Commission, dated
December 2, 2009 (``Bluefin Statement''); John C. Nagel, Managing
Director and Deputy General Counsel, Citadel, to Elizabeth M.
Murphy, Commission, dated December 3, 2009 (``Citadel Statement'');
Janet M. Kissane, Senior Vice President--Legal & Corporate
Secretary, NYSE Euronext, to Elizabeth M. Murphy, Secretary,
Commission, dated December 3, 2009 (``NYSE Statement 1''); and
Angelo Evangelou, Assistant General Counsel, CBOE, to Elizabeth M.
Murphy, Secretary, Commission, dated January 20, 2010 (``CBOE
Statement 2''). The Commission also received a statement from ISE
responding to the CBOE Statement 2 regarding its statistical claim
and number of trade-throughs. See Letter from Michael J. Simon,
Secretary, ISE, to Elizabeth M. Murphy, Secretary, Commission, dated
March 1, 2010.
---------------------------------------------------------------------------
2. Commenter's to ISE's Original QCC Order Proposal
In its Petition for Review and statements in support thereof, CBOE
argued that ISE's Original QCC Order proposal was inconsistent with the
Act \30\ and raised important policy concerns that the Commission
should address, including whether crossing straight or complex option
orders without exposure is appropriate and whether permitting a
``clean'' cross in front of public customer orders is appropriate. CBOE
believed that ISE's proposal was inconsistent with the Act because ``it
effectively establishes ISE as a print facility for large options
orders rather than an exchange where orders are able to interact in an
auction setting.'' \31\ CBOE and certain commenters objected to the
Original QCC Order proposal because, for crosses that satisfy the QCC's
requirements, a member of ISE could execute a clean cross without
exposing the cross to other ISE participants, which CBOE stated would
represent a significant change from historical and current market
practices in the options markets.\32\ CBOE contended that the
Commission's policy and practice had been to limit the percentage of
the crossing entitlement to an amount below 50% of the order being
executed, and then only after ensuring that all crossing entitlements
are exposed and yield to public customer orders.\33\ CBOE stated that
the policies requiring exposure and yielding to public customer
interest balance ``the desire to permit internalization/solicitations
to some degree while at the same time ensuring competition and price
discovery and, to some degree, protecting public customers (including
retail investors).'' \34\ Without an exposure requirement, CBOE
contended that the proposal would have a major adverse impact on
options market structure, and result in a trading environment that is
``sluggish, nontransparent, and noncompetitive.'' \35\
---------------------------------------------------------------------------
\30\ See e.g., Petition for Review, supra note 22, at 11. See
also CBOE Statement 1, supra note 29, at 5-6, 15-16.
\31\ See Petition for Review, supra note 22, at 13. See also
Bluefin Statement, supra note 29; Citadel Statement, supra note 29,
at 2; and LiquidPoint Letter, supra note 26, at 4. See also
Wolverine Letter, supra note 26 and CBOE Statement 1, supra note 29,
at 8.
\32\ See Petition for Review, supra note 22, at 5, 9, 13-15. See
also Bluefin Statement, supra note 29; Citadel Statement, supra note
29, at 2; NYSE Statement 1, supra note 29, at 2; Wolverine Letter,
supra note 26; and LiquidPoint Letter, supra note 26, at 2.
\33\ See Petition for Review, supra note 22, at 5, 17. CBOE also
noted ISE's investment in an entity that CBOE asserted is ``geared
towards the non-transparent execution of block size stock-option
transactions,'' which CBOE contended would benefit from the ISE's
proposal. Id. at 11. See also CBOE Statement 1, supra note 29, at
13-14.
\34\ See Petition for Review, supra note 22, at 15.
\35\ Id. at 10, 14. CBOE and some commenters also noted their
belief that the lack of exposure also degrades market transparency,
which they believe is related to the Commission's concerns relating
to dark pools. Id. at 16. See also, e.g., NYSE Statement 1, supra
note 29, at 1, 4.
---------------------------------------------------------------------------
CBOE and many of the commenters to the Original QCC Order proposal
believed that the lack of any exposure requirement in ISE's Original
QCC Order would have a detrimental effect on the options market as it
would provide a disincentive to ISE's market makers to quote
competitively, undercut their market making function and could result
in market makers migrating off other exchanges that do not offer a QCC
Order type to ISE, to take advantage of potentially wider spreads and
where greater margins might be available with
[[Page 11536]]
less competitive quoting.\36\ One commenter stated that the Original
QCC Order, by preventing market makers from participating in trades
occurring at their quoted prices, would cause market makers to spread
their quotes wider to increase their profit margins in compensation for
the lower volume of trading in which they participate.\37\ This
commenter further stated that, eventually, such market makers might
very well question the wisdom of committing capital to make firm
markets in the thousands of options series in which they have
continuous quoting obligations.\38\ Another commenter noted that,
ultimately, this would ``increase the costs and decrease the
availability of proven, effective risk management through derivatives''
and harm options market participants, as their ability ``to execute
their myriad strategies would disappear.'' \39\ Thus, some commenters
believed that permitting the implementation of the QCC Order would harm
the growth prospects of the overall options industry.\40\
---------------------------------------------------------------------------
\36\ See CBOE Statement 1, supra note 29, at 8; NYSE Statement
1, supra note 29 at 2, 3; and LiquidPoint Letter, supra note 26, at
3, 5. See also Petition for Review, supra note 22, at 13.
\37\ See NYSE Statement 1, supra note 29 at 3.
\38\ Id.
\39\ See LiquidPoint Letter, supra note 26, at 3, 5.
\40\ See NYSE Statement 1, supra note 29, at 2 and LiquidPoint
Letter, supra note 26, at 3-5. See also CBOE Statement 1, supra note
29, at 8.
---------------------------------------------------------------------------
However, ISE argued that the QCC Order type would not impact the
options markets, and that large-size contingency orders are executed on
floor-based exchanges in a manner very similar to the new order type
proposed by ISE. In addition, ISE noted that there is no meaningful
transparency on floors because there is no requirement that information
on orders presented to the floor be announced electronically to all
exchange members or the public.\41\ ISE also noted that some floor-
based options exchanges have eliminated the requirement that market
makers have a physical presence on the floor, which it believes
undermines the claim that price discovery and transparency occur on the
trading floor.\42\ One commenter to the Original QCC Order proposal
agreed and stated that the exposure-related concerns of other
commenters ``do not adequately recognize the reality of how this
business is conducted today and seem to simply endorse a manual trading
environment that prevents competition from electronic exchanges.'' \43\
---------------------------------------------------------------------------
\41\ See ISE Statement 1, supra note 28, at 2, 6.
\42\ Id.
\43\ See Capstone Statement, supra note 28, at 2.
---------------------------------------------------------------------------
In addition to CBOE's opposition to the Original QCC Order because
of its lack of an exposure requirement, CBOE also argued that public
customers that have previously placed limit orders at the execution
price of a QCC Order would be harmed because those customers would lose
priority and would not receive executions of their resting orders.\44\
CBOE expressed concern that, because certain customer orders would not
receive priority, the proposal would create a disincentive to placing
limit orders.\45\ CBOE maintained that, with respect to intra-market
priority in the exchange-listed options markets, the long-standing
industry policy and practice has been to require public customer
priority for simple option orders.\46\ Two commenters also expressed
concern that the Original QCC Order would cause public customers with
existing orders to be disadvantaged in the executions that they receive
and would be a direct disincentive to market makers and would likely
encourage wider quoted markets.\47\
---------------------------------------------------------------------------
\44\ See Response to Motion, supra note 24, at 4.
\45\ See Petition for Review, supra note 22, at 13.
\46\ Id. at 17. See also CBOE Statement 1, supra note 29, at 5,
9.
\47\ See Bluefin Statement, supra note 29 and NYSE Statement 1,
supra note 29 at 2.
---------------------------------------------------------------------------
ISE disagreed with the commenters' claims that public customers
with resting limit orders would be harmed by its QCC proposal. ISE
stated that large-size contingency trades that would qualify as QCC
Orders are currently almost exclusively executed on floor-based
exchanges, thus ``the occasional customer limit order resting on ISE's
book * * * has no opportunity to interact with [such orders].'' \48\
---------------------------------------------------------------------------
\48\ See ISE Statement 1, supra note 28, at 2, 5.
---------------------------------------------------------------------------
In addition, CBOE stated that no execution entitlements have been
permitted thus far, unless there is first yielding to public customer
interest.\49\ CBOE contrasted the Original QCC Order with the rules of
all options exchanges relating to net-priced complex orders, which
require that each options leg(s) of the complex order trade at or
inside the NBBO and, at a minimum, price improve public customer orders
in at least one component options leg.\50\ CBOE also noted that, in a
stock-option order net-priced package, it has been the Commission
policy to require that the option leg of the stock-option order either
yield to the same priced public customer order represented in the
individual options series or trade at a better price.\51\ CBOE argued
that the Original QCC Order, in contrast, would be given special
priority that goes beyond the priority afforded to packaged stock-
option orders by permitting it to be crossed without giving priority to
public customers.\52\
---------------------------------------------------------------------------
\49\ See Petition for Review, supra note 22, at 15.
\50\ Id. at 18.
\51\ Id.
\52\ Id. at 19.
---------------------------------------------------------------------------
In response, ISE noted that there are many examples of exception to
rules to accommodate specific trading strategies.\53\ ISE further
argued that there is no basis under the Act to prevent exchanges from
adopting market structures and priority rules that are tailored for
large-size contingent orders and that customer priority is not required
in all circumstances.\54\
---------------------------------------------------------------------------
\53\ See ISE Statement 1, supra note 28, at 2, 5. For example,
ISE pointed to the existing rules of the options exchanges that
permit the execution of one leg of a complex trade at the same price
as a public customer order on the limit order book if another leg of
the order is executed at an improved price. See CBOE Rule 6.45A.
\54\ Id.
---------------------------------------------------------------------------
Commenters to the Original QCC Order also questioned whether the
customer involved in the QCC Order would be able to receive the best
price for its order because, without a requirement for the order to be
exposed, the submitting member's customer would not have the
opportunity to receive price improvement for the options leg of the
order.\55\ Specifically, CBOE expressed concern that, because the QCC
Order would eliminate the requirement of market exposure, the customer
whose order is submitted through the QCC Order mechanism might receive
a fill at a price that is inferior to the price the customer would have
received if the full package or even the options component had been
represented to the market.\56\
---------------------------------------------------------------------------
\55\ See CBOE Statement 1, supra note 29, at 7-8 and Petition
for Review, supra note 22, at 13. See also Bluefin Statement, supra
note 29; Group One Letter, supra note 26, at 1-2; and Integral
Derivatives Letter, supra note 26.
\56\ See CBOE Statement 1, supra note 29, at 7.
---------------------------------------------------------------------------
ISE responded to these concerns by explaining that, when
negotiating a stock-option order, market participants agree to a ``net
price,'' i.e., a price that reflects the total price of both the
options and stock legs of the transaction which are executed separately
in the options and equity markets.\57\ Accordingly, ISE believed that,
for such trades, the actual execution price of each component is not as
material to the parties to the trade as is the net price of the
transaction.\58\
---------------------------------------------------------------------------
\57\ See ISE Statement 1, supra note 28, at 2, 6.
\58\ See id.
---------------------------------------------------------------------------
[[Page 11537]]
3. RiskFin Analysis of Large-Size Contingency Orders
In support of the Original QCC Order, ISE stated that its proposed
QCC Order provided an all-electronic alternative to the open-outcry
execution of large stock-option trades on floor-based exchanges. While
both all-electronic exchanges and floor-based exchanges have rules that
require exposure of an order before a member is permitted to trade with
such order, ISE believes that the requirement under ISE's rules is
significantly more onerous than the similar requirement of floor-based
exchanges, where such exchanges are only required to expose such orders
to their members on the floor and not electronically to all members.
Accordingly, ISE asserted, among other things, that it needed the QCC
Order to remain competitive with other exchanges, particularly floor-
based exchanges, because although these orders are exposed on the
floor-based exchanges, they are rarely broken up.\59\
---------------------------------------------------------------------------
\59\ See ISE Reply, supra note 25, at 5.
---------------------------------------------------------------------------
In order to examine ISE's contention with respect to activity on
floor-based exchanges regarding large-sized contingent trades, in
October 2009, the Commission's Division of Risk, Strategy and Financial
Innovation (``RiskFin'') requested Consolidated Options Audit Trail
System (``COATS'') data from certain options exchanges for each Tuesday
in August and September of 2009. On March 17, 2010, RiskFin placed in
the public file a memorandum analyzing the COATS data, in which it
presented the findings of its analysis of ISE's contention that large-
size contingency orders on floor-based exchanges were never or nearly
never broken up.\60\ The RiskFin Analysis provided some support for
ISE's contention that large orders are broken up less frequently on
floor-based exchanges than on an electronic exchange, though it did not
definitively confirm ISE's contention. Specifically, in examining the
percentage of trades that are either fully or near-fully executed
against a single contra-party, the RiskFin Analysis showed that, for
trades with a size of 2,000 contracts or more, only 12% were completely
executed with only one execution on ISE, compared to 26% and 29% of
trades that were filled with only one execution on two floor-based
exchanges. Similarly, the data also showed that for orders of 2,000
contacts or more, only 16% of orders on ISE were 90% filled against a
single contra-party, while the comparable figures for two floor-based
exchanges were 35% and 37%.
---------------------------------------------------------------------------
\60\ See Memorandum Regarding ISE Qualified Contingent Cross
Proposal from Division of Risk, Strategy and Financial Innovation,
dated March 1, 2010 (``RiskFin Analysis'') (available at http://www.sec.gov/rules/other/2010/sr-ise-2009-35/riskfinmemo030110.pdf).
The RiskFin Analysis reviewed COATS data from ISE, CBOE and Phlx.
---------------------------------------------------------------------------
While the RiskFin Analysis provided the percentage of orders on
each exchange that were filled in a single execution versus multiple
executions, the COATS data used for the analysis was not limited to
facilitation orders.\61\ Thus, the RiskFin Analysis was not dispositive
with respect to ISE's contention because it contained orders unrelated
to ISE's proposed order type. Concurrently with the placement of the
RiskFin Analysis in the public file, the Commission issued an order
extending the time to file a statement in support of or in opposition
to the Original Approval Order.\62\ Subsequently, the Commission
received three statements relating to the RiskFin Analysis.\63\
---------------------------------------------------------------------------
\61\ For example, ISE notes that the inclusion of index options
trading in the data distorts the extent to which there is ``break-
up'' of large crosses on the floor-based exchanges and believes that
excluding index options from the RiskFin Analysis would
significantly increase the number of floor-based exchanges' large
orders that were executed without break-up. See ISE Statement 3,
infra note 63, at 2-3.
\62\ See Commission Order Extending Time to File Statements,
dated March 17, 2010.
\63\ See Letters from Edward J. Joyce, President and Chief
Operating Officer, CBOE, to Elizabeth M. Murphy, Secretary,
Commission, dated April 7, 2010 (``CBOE Statement 3''); Pia K.
Bennett, Associate Corporate Secretary, NYSE Euronext, to Elizabeth
M. Murphy, Secretary, Commission, dated April 7, 2010 (``NYSE
Statement 2''); and Michael J. Simon, Secretary, ISE, to Elizabeth
M. Murphy, Secretary, Commission, dated April 7, 2010 (``ISE
Statement 3'').
---------------------------------------------------------------------------
Both CBOE and ISE focused on the RiskFin Analysis and noted that
the ``analysis did not confirm ISE's contention that large orders are
broken-up less frequently on floor-based exchanges, though certain data
did provide support for ISE's position.'' Although CBOE believed that
the conclusion was favorable to its opposing position on ISE's QCC
Order type, it clarified that it did not believe the study was
necessary and that the policy question of exposure and whether it would
benefit investors or not was the critical concern.\64\
---------------------------------------------------------------------------
\64\ See CBOE Statement 3, supra note 63, at 1 and 4.
---------------------------------------------------------------------------
Alternatively, ISE believed that the RiskFin Analysis conclusion
strongly supported ISE's position that the QCC Order type is an
appropriate and necessary competitive tool for the ISE.\65\ In support
of its belief, ISE noted that the most critical statistic in
determining whether exchange members can affect a trade without being
broken up is to look at how often large trades are executed in a single
execution. ISE points to the RiskFin Analysis data that demonstrates
that for the largest trades (2,000 or more contracts) only 12% of such
trades were executed without a break-up on the ISE, while the
percentages for the two floor-based exchanges were more than twice as
high.\66\
---------------------------------------------------------------------------
\65\ See ISE Statement 3, supra note 63, at 2.
\66\ Id. at 2.
---------------------------------------------------------------------------
Another commenter reiterated its concern that the proposed QCC
Order type creates a disincentive to competitively quote by limiting
price discovery opportunities and dampens transparency in the options
markets.\67\ In response to the RiskFin Analysis data, the commenter
stated that the crossing of two orders on or within the best bid or
offer of the options markets, with no interference from other
participants despite exposure to the market, indicated that the cross
was fairly priced as part of the off-exchange negotiation and that
without exposure, there is no such comfort that the best possible price
was obtained.\68\
---------------------------------------------------------------------------
\67\ See NYSE Statement 2, supra note 63, at 1.
\68\ Id. at 3.
---------------------------------------------------------------------------
4. Request To Vacate SR-ISE-2009-35 Original Approval Order
On July 14, 2010, concurrently with the filing of the current
proposal to modify the rules for QCC Orders (i.e., SR-ISE-2010-73), the
Commission received a letter from ISE requesting the Commission to
vacate the Original Approval Order concurrently with an approval of SR-
ISE-2010-73.\69\ Specifically, the Vacate Letter stated that ISE
submitted its current proposal to address the most significant issues
that commenters raised regarding the Original QCC Order.
---------------------------------------------------------------------------
\69\ See Letter from Michael J. Simon, Secretary, ISE, to
Elizabeth M. Murphy, Secretary, Commission, dated July 14, 2010
(``Vacate Letter'').
---------------------------------------------------------------------------
D. Description of Current Proposal To Modify QCC Order Rules
As noted above, among their objections to ISE's Original QCC Order,
CBOE and some commenters argued that public customers with limit orders
resting on ISE's book at the execution price of a QCC Order would be
harmed because the QCC Order would execute ahead of their resting
orders and that, because certain customer orders would not receive
priority, the proposal would create a disincentive to placing limit
orders.\70\ CBOE and some commenters also questioned whether the
customer involved in the QCC Order would be able to receive the best
price for its
[[Page 11538]]
order because, without a requirement for the order to be exposed, the
submitting member's customer would not have the opportunity to receive
price improvement for the options leg of the order.\71\
---------------------------------------------------------------------------
\70\ See, e.g., Petition for Review, supra note 22, at 13, 15,
17. See also Bluefin Statement, supra note 29; Phlx Letter, supra
note 26; Wolverine Letter, supra note 26; Group One Letter, supra
note 26, at 1; and Integral Derivatives Letter, supra note 26.
\71\ See, e.g., CBOE Statement 1, supra note 29, at 7-8 and
Petition for Review, supra note 22, at 13. See also Bluefin
Statement, supra note 29; Group One Letter, supra note 26, at 1-2;
and Integral Derivatives Letter, supra note 26.
---------------------------------------------------------------------------
Though ISE believes that there is nothing novel about granting or
not granting customer priority, that the Commission had approved
exchange rules that do not provide customer priority, and that there is
no statutory requirement that customer orders receive priority,\72\ in
SR-ISE-2010-73 the Exchange proposes to modify the Original QCC Order
rules to require that a QCC Order be automatically cancelled if there
are any Priority Customer \73\ orders on the Exchange's limit order
book at the same price. This modification thus prohibits QCC Orders
from trading ahead of Priority Customer orders. In addition, in SR-ISE-
2010-73, ISE proposes to increase the minimum size requirement for a
QCC Order from 500 contracts to 1,000 contracts. ISE contends that such
an increase supports the Exchange's intention to permit the crossing of
only large-sized institutional stock-option orders.\74\
---------------------------------------------------------------------------
\72\ See ISE Statement 1, supra note 28, at 4. See also Capstone
Statement, supra note 28, at 2.
\73\ Under ISE Rule 100(37A), a priority customer is a person or
entity that (i) is not a broker or dealer in securities, and (ii)
does not place more than 390 orders in listed options per day on
average during a calendar month for its own beneficial account(s).
Pursuant to ISE Rule 713, priority customer orders are executed
before other trading interest at the same price.
\74\ See Vacate Letter, supra note 69, at 1.
---------------------------------------------------------------------------
Thus, as modified, an ISE member effecting a trade pursuant to the
NMS QCT Exemption could cross the options leg of the trade on ISE as a
QCC Order immediately upon entry, without exposure, only if there are
no Priority Customer orders on the Exchange's limit order book at the
same price and if the order: (i) Is for at least 1,000 contracts; (ii)
meets the six requirements of the NMS QCT Exemption; \75\ and (iii) is
executed at a price at or between the NBBO (``Modified QCC
Order'').\76\ In the Notice, ISE stated that the modifications to the
Original QCC Order (i.e., to prevent the execution of a QCC if there is
a Priority Customer on its book and to increase the minimum size of a
QCC Order) remove the appearance that such orders are trading ahead of
Priority Customer orders or that the QCC Order could be used to
disadvantage retail customers.\77\
---------------------------------------------------------------------------
\75\ See supra notes 9 and 13 and accompanying text.
\76\ If there are Priority Customer orders on ISE's limit order
book at the same price, the QCC Order would be automatically
canceled. See proposed ISE Rule 721(b)(1).
\77\ See Notice, supra note 3.
---------------------------------------------------------------------------
E. Commenters to ISE's Modified QCC Order Proposal
The Commission received eight comment letters opposing ISE's
Modified QCC Order proposal and a response letter from ISE.\78\ While
some commenters noted that ISE had addressed their prior objections
relating to customer priority,\79\ commenters objected to ISE's
modified proposal because it remained unchanged from the original
proposal with respect to exposure, in that QCC Orders would still be
crossed without exposure.\80\ Commenters noted that exposure is
especially critical in the options market, which is quote-driven and
relies on market makers to ensure that two-sided quotations are
available for hundreds of thousands of different options series.\81\
Commenters argued that exposure, in addition to allowing for the
possibility of price improvement, provides market makers an opportunity
to participate in trades, which in turn provides them incentives to
quote aggressively, thus benefiting the market as a whole.\82\
---------------------------------------------------------------------------
\78\ See supra notes 4 and 5.
\79\ See CBOE Letter 1, supra note 4, at 1, NYSE Letter 2, supra
note 4, at 7, and Susquehanna Letter 2, supra note 4, at 1. See also
supra notes 44-54 and accompanying text.
\80\ See CBOE Letter 1, supra note 4, at 1; Phlx Letter 2, supra
note 4, at 1; LiquidPoint Letter 2, supra note 4, at 1-2; Group One
Letter 2, supra note 4, at 1; NYSE Letter 2, supra note 4, at 1-2,
7-8; and Susquehanna Letter 2, supra note 4, at 1.
\81\ See CBOE Letter 1, supra note 4, at 1-2; Phlx Letter 2,
supra note 4, at 1; LiquidPoint Letter 2, supra note 4, at 1, 2;
Group One Letter 2, supra note 4, at 2; NYSE Letter 2, supra note 4,
at 3, 7-8; NYSE Letter 3, supra note 4, at 2; and Susquehanna Letter
2, supra note 4, at 3.
\82\ See CBOE Letter 1, supra note 4, at 2-3 and Phlx Letter 2,
supra note 4, at 1. See also Cutler Letter, supra note 4 (stating
that without exposure, there is no incentive for market makers to
display liquidity, provide liquidity or offer price improvement) and
LiquidPoint Letter 2, supra note 4, at 2 (stating that if market
makers are not able to participate in all price discovery
opportunities, they would be left to participate in only price
discovery opportunities that are less-desirable and that the result
of this negative selection would be ``increased risk, a higher
probability of unprofitable trades and a reticence to post their
best markets. See also Group One Letter 2, supra note 4, at 2; NYSE
Letter 2, supra note 4, at 2, 3; and Susquehanna Letter 2, supra
note 4, at 3.
---------------------------------------------------------------------------
Relatedly, several commenters warned against removing incentives
for liquidity providers in light of the market events of May 6,
2010.\83\ One commenter noted that any tightening of market maker
obligations could only succeed if market maker benefits were
correspondingly aligned, and argued that ISE's proposal would withdraw
significant options order flow and, thus, the opportunity for market
makers to interact with that order flow via exposure.\84\
---------------------------------------------------------------------------
\83\ See CBOE Letter 1, supra note 4, at 1, 3-4; Group One
Letter 2, supra note 4, at 2; and NYSE Letter 2, supra note 4, at 2.
\84\ See CBOE Letter 1, supra note 4, at 3.
---------------------------------------------------------------------------
In addition, CBOE stated that order exposure and the opportunity
for market participant interaction was integrally related to what
constitutes an exchange and stressed that the Commission should not
abandon such long-held standards to permit ``print'' mechanisms on
options exchanges, which it believed the ISE proposal to be.\85\ CBOE
and NYSE also noted that the Commission has generally not permitted
100% participation guarantees, as the QCC Order would provide for.\86\
---------------------------------------------------------------------------
\85\ See CBOE Letter 1, supra note 4, at 3, 5.
\86\ See NYSE Letter 2, supra note 4, at 3; NYSE Letter 3, supra
note 4, at 1-2; and CBOE Letter 1, supra note 4, at 2.
---------------------------------------------------------------------------
CBOE also noted that the component legs of stock-option orders are
exposed on options exchanges as a package (e.g., through complex order
mechanisms) with all terms of the complete order being transparent to
the marketplace.\87\ This commenter noted that such stock-option
orders, while still requiring exposure, are granted intermarket trade-
through relief. In contrast, this commenter saw no reason why QCC
Orders should receive any special treatment (i.e., not be required to
be exposed) and noted that they are not represented as a package and
thus do not provide the same transparency as stock-option orders, with
only upstairs parties to these trades aware of the complete terms of
the total transaction.\88\ In response, ISE reiterated its belief that
the crossing of large-size contingency orders on a floor today is not
transparent because ``there are very few traders (if any) on the floor
to hear an order `announced''' and are executed with little, if any.
interruption.\89\ ISE stated that commenters opposed to its proposal
were arguing about the theoretical benefits of exposure and ignoring
the realities of what is occurring in the markets.\90\ Further, ISE
stated that, currently, members arrange large stock-option trades
upstairs and then bring them to an exchange for execution. Floor
exchanges, ISE argued, accommodate these trades by providing a market
structure where there is little
[[Page 11539]]
or no chance that members will break up the pre-arranged trade.\91\
Another commenter believed that splitting a stock-option order into
separate executions for the individual stock and options legs, rather
than representing the stock-option order as a package, was generally
not in the best interest of the customer from a best execution point of
view.\92\
---------------------------------------------------------------------------
\87\ See CBOE Letter 1, supra note 4, at 4-5. See also NYSE
Letter 2, supra note 4, at 4.
\88\ See CBOE Letter 1, supra note 4, at 4-5. See also Cutler
Letter, supra note 4; and NYSE Letter 2, supra note 4, at 4.
\89\ See ISE Statement 1, supra note 28, at 3.
\90\ See ISE Response, supra note 5, at 2.
\91\ Id.
\92\ See Susquehanna Letter 2, supra note 4, at 4-5.
---------------------------------------------------------------------------
Another commenter reiterated its belief that the benefits of price
discovery and transparency afforded by exposure were especially crucial
for broker facilitated crosses such as QCC Orders because of the
inherent conflict of interest for such orders since a broker is
``betting against the customer'' in such trades.\93\ Commenters also
contended that ISE's claim that it needed the QCC Order to compete with
trading on floor-based exchanges is erroneous and disingenuous, and
that it ignored the broader ramification of QCC Orders that, whereas
trading floors require exposure of orders before any executions can
occur, the QCC Order would ensure that exposure was eliminated
altogether.\94\
---------------------------------------------------------------------------
\93\ See Group One Letter 2, supra note 4, at 1-2. See also
supra note 55 and accompanying text.
\94\ See CBOE Letter 1, supra note 4, at 4-5. See also NYSE
Letter 2, supra note 4, at 3-4 and NYSE Letter 3, supra note 4, at
2.
---------------------------------------------------------------------------
With respect to the increase in contract size for QCC Orders from
500 contracts (as originally proposed in SR-ISE-2009-35) to 1,000
contracts, NYSE questioned whether the change was meaningful in
limiting the scope of the proposed QCC Order type, as it believed that
market participants could game the rule to meet this requirement,\95\
while another commenter believed that the 1,000 contract requirement
was a relatively low threshold that would permit large broker-dealers
to shut out other market participants on relatively small trades.\96\
---------------------------------------------------------------------------
\95\ See NYSE Letter 2, supra note 4, at 5-7 and NYSE Letter 3,
supra note 4, at 3.
\96\ See Cutler Letter, supra note 4.
---------------------------------------------------------------------------
In its response letter, ISE reiterated its argument that its QCC
Order proposals were simply a way for ISE to compete against floor-
based options exchanges for the execution of large stock-option
orders.\97\ ISE countered commenters' arguments regarding the lack of
exposure of QCC Orders by stating that the required exposure of orders
on floor-based exchanges was nominal and theoretical, and ignores the
realities of what is occurring on those markets.\98\ One commenter
agreed with ISE's assertion that floor-based options exchanges enjoy an
unfair competitive advantage over all-electronic options exchanges for
executing clean blocks, noting that, in its own experience,
``institutional brokers are much more apt to use a trading floor when
the primary intention is to execute as clean a cross as possible.''
\99\ ISE stated its belief that floor-based options markets accommodate
such trades by ``providing a market structure in which there is little
or no chance that members will break up the pre-arranged trade'' by
structuring their markets to provide such trades with the least amount
of ``friction.'' \100\ ISE contended that, if floor-based exchanges
were serious about exposure, they would expose such orders to their
entire marketplace, rather than limiting exposure to ``those few (if
any) members physically present in the floor-based trading crowd.''
\101\ One commenter echoed ISE's contention and suggested that a common
rule for all block crosses on all options exchanges should be adopted
to require all pre-negotiated option block crosses, including floor
crosses, to be entered into an electronic crossing mechanism. This
commenter believed that such a requirement would ensure that market
makers could compete for such orders and thus provide the orders a
greater chance at price improvement, as well as act as a check to
ensure that the brokers facilitating these orders priced them
competitively.\102\
---------------------------------------------------------------------------
\97\ See ISE Response, supra note 5, at 1-2.
\98\ Id. at 2.
\99\ See Susquehanna Letter 2, supra note 4, at 2.
\100\ Id.
\101\ Id.
\102\ See Susquehanna Letter 2, supra note 4, at 2.
---------------------------------------------------------------------------
ISE also countered commenters' arguments that the QCC Order
proposal, because it does not provide for exposure, would not allow for
price improvement by reiterating its prior explanation that those
parties involved in a stock-option order negotiate such transactions on
a ``net price'' basis, reflecting the total price of both the stock and
options legs of the trade. Thus, ISE argued, the actual execution price
of each individual component is not as material to the parties involved
as is the net price of the entire transaction, which ISE believes means
that price improvement of the individual legs of the trade is not a
critical issue in the execution of a QCC Order.\103\
---------------------------------------------------------------------------
\103\ See ISE Response, supra note 5, at 3-4.
---------------------------------------------------------------------------
In addition, ISE argued that its QCC Order proposal has no
relevance to the market events of May 6, 2010, despite commenters'
attempts to link the two. ISE again noted that large stock-options
trades are currently arranged upstairs and then shopped among exchanges
to achieve a clean cross.\104\ ISE argued that, accordingly, large
stock-option trades today ``rely on the liquidity that firms can
provide in arranging these trades and do not now include exchange-
provided liquidity.'' \105\ ISE believed that the QCC Order type would
simply provide a competitive electronic vehicle for such trades and
will have no effect on available liquidity.\106\
---------------------------------------------------------------------------
\104\ See ISE Response, supra note 5, at 4.
\105\ Id.
\106\ Id.
---------------------------------------------------------------------------
In response to NYSE's contention that the QCC Order's contract size
requirement could be gamed, ISE noted that any member creating ``fake
customer orders'' would be misrepresenting its order in violation of
ISE's rules and expressed confidence that its surveillance program
would be able to catch any such attempt.\107\ In addition, ISE
clarified the calculation of the 1,000 contract minimum size for a QCC
Order noting that, in order to meet this requirement, an order must be
for at least 1,000 contracts and could not be, for example, two 500
contract orders or two 500 contract legs.\108\
---------------------------------------------------------------------------
\107\ Id. at 5-6.
\108\ Id. at 6.
---------------------------------------------------------------------------
III. Discussion and Commission Findings
After careful review, the Commission finds that the proposed rule
change is consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities exchange
and, in particular, with Section 6(b) of the Act.\109\ Specifically,
the Commission finds that the proposal is consistent with Sections
6(b)(5) \110\ and 6(b)(8),\111\ which require, among other things, that
the rules of a national securities exchange be designed to promote just
and equitable principles of trade, to remove impediments to and perfect
the mechanism of a free and open market and a national market system,
and, in general, to protect investors and the public interest and that
the rules of an exchange do not impose any burden on competition not
necessary or appropriate in furtherance of the purposes of the Act. In
addition, the Commission finds that the proposed rule change is
consistent with Section 11A(a)(1)(C) of the Act,\112\ in which Congress
found that it is in the public
[[Page 11540]]
interest and appropriate for the protection of investors and the
maintenance of fair and orderly markets to assure, among other things,
the economically efficient execution of securities transactions.
---------------------------------------------------------------------------
\109\ 15 U.S.C. 78f(b). In approving this proposed rule change,
the Commission has considered the proposed rule's impact on
efficiency, competition, and capital formation. See 15 U.S.C.
78c(f).
\110\ 15 U.S.C. 78f(b)(5).
\111\ 15 U.S.C. 78f(b)(8).
\112\ 15 U.S.C. 78k-1(a)(1)(C).
---------------------------------------------------------------------------
A. Consistency With the NMS QCT Exemption
In approving the Original QCT Exemption, the Commission recognized
that contingent trades can be ``useful trading tools for investors and
other market participants, particularly those who trade the securities
of issuers involved in mergers, different classes of shares of the same
issuer, convertible securities, and equity derivatives such as options
[italics added].'' \113\ The Commission stated that ``[t]hose who
engage in contingent trades can benefit the market as a whole by
studying the relationships between the prices of such securities and
executing contingent trades when they believe such relationships are
out of line with what they believe to be fair value.'' \114\ As such,
the Commission stated that transactions that meet the specified
requirements of the NMS QCT Exemption could be of benefit to the market
as a whole, contributing to the efficient functioning of the securities
markets and the price discovery process.\115\
---------------------------------------------------------------------------
\113\ See Original QCT Exemption, supra note 9, at 52830.
\114\ Id. at 52831.
\115\ See CBOE QCT Exemption, supra note 13.
---------------------------------------------------------------------------
The parties to a contingent trade are focused on the spread or
ratio between the transaction prices for each of the component
instruments (i.e., the net price of the entire contingent trade),
rather than on the absolute price of any single component.\116\
Pursuant to the requirements of the NMS QCT Exemption, the spread or
ratio between the relevant instruments must be determined at the time
the order is placed, and this spread or ratio stands regardless of the
market prices of the individual orders at their time of execution. As
the Commission noted in the Original QCT Exemption, ``the difficulty of
maintaining a hedge, and the risk of falling out of hedge, could
dissuade participants from engaging in contingent trades, or at least
raise the cost of such trades.'' \117\ Thus, the Commission found that,
if each stock leg of a qualified contingent trade were required to meet
the trade-through provisions of Rule 611 of Regulation NMS, such trades
could become too risky and costly to be employed successfully and noted
that the elimination or reduction of this trading strategy potentially
could remove liquidity from the market.\118\
---------------------------------------------------------------------------
\116\ See Original QCT Exemption, supra note 9, at 52829
(explaining SIA's position on the need for the Original QCT
Exemption).
\117\ Id. at 52831.
\118\ Id.
---------------------------------------------------------------------------
The Commission believes that ISE's proposal, which would permit a
clean cross of the options leg of a subset of qualified contingent
trades (i.e., a stock-option qualified contingent trade that meets the
requirements of the NMS QCT Exemption), is appropriate and consistent
with the Act in that it would facilitate the execution of qualified
contingent trades, for which the Commission found in the Original QCT
Exemption to be of benefit to the market as a whole, contributing to
the efficient functioning of the securities markets and the price
discovery process.\119\ The QCC Order would provide assurance to
parties to stock-option qualified contingent trades that their hedge
would be maintained by allowing the options component to be executed as
a clean cross.
---------------------------------------------------------------------------
\119\ Id.
---------------------------------------------------------------------------
B. Exposure and Qualified Contingent Trades
Commenters believed that ISE's modifications to the Original QCC
Order did not adequately address their main objection regarding the QCC
Order, particularly in that it would continue to permit option crosses
to occur without prior exposure to the marketplace. Commenters
generally reiterated their prior comments that exposing options orders
promotes price competition, increases order interaction, and leads to
better quality executions for investors by providing opportunities for
price improvement.\120\ These commenters continued to argue that,
without exposure, the Modified QCC Order would cause significant harm
to the options market because it would eliminate valuable incentive for
dedicated liquidity provider participation.\121\
---------------------------------------------------------------------------
\120\ See supra notes 70 and 85-94 and accompanying text.
\121\ See supra notes 81-84 and accompanying text.
---------------------------------------------------------------------------
In response to commenters' concerns that the Modified QCC Order
would have a detrimental effect on the options markets because of the
lack of any exposure requirement, ISE stated that exchange members
arrange large stock-option trades upstairs and then bring them to an
exchange for execution, and that exchange floors accommodate the trades
by providing a market structure in which there is little or no chance
that members will break up the pre-arranged trade.\122\ ISE believed
that, rather than harming the options markets, the QCC proposal would
permit fair competition to occur between floor-based and all-electronic
options exchanges by providing an all-electronic execution alternative
to floor-based executions.\123\
---------------------------------------------------------------------------
\122\ See supra notes 97-100 and accompanying text.
\123\ See ISE Response, supra note 5, at 3.
---------------------------------------------------------------------------
The Commission recognizes that significant liquidity on options
exchanges is derived from quotations submitted by members of an
exchange that are registered as market makers.\124\ Pursuant to the
options exchanges' rules, market makers generally are required to
maintain continuous two-sided quotations in their registered options
for a specified percentage of the time, or in a specified number of
series or classes. One of the perceived benefits for market makers with
such obligations is the opportunity to participate in transactions
through the exposure requirement. As noted above, some commenters argue
that the lack of exposure for QCC Orders would act as a disincentive
for market maker participation.\125\
---------------------------------------------------------------------------
\124\ See, e.g., Susquehanna Letter 2, supra note 4, at 3
(noting that, in the options market, market makers provide over 90%
of the liquidity).
\125\ See supra notes 81-82 and accompanying text.
---------------------------------------------------------------------------
While the Commission believes that order exposure is generally
beneficial to options markets in that it provides an incentive to
options market makers to provide liquidity and therefore plays an
important role in ensuring competition and price discovery in the
options markets, it also has recognized that contingent trades can be
``useful trading tools for investors and other market participants,
particularly those who trade the securities of issuers involved in
mergers, different classes of shares of the same issuer, convertible
securities, and equity derivatives such as options [italics
added]''.\126\ and that ``[t]hose who engage in contingent trades can
benefit the market as a whole by studying the relationships between the
prices of such securities and executing contingent trades when they
believe such relationships are out of line with what they believe to be
fair value.'' \127\ As such, the Commission stated that transactions
that meet the specified requirements of the NMS QCT Exemption could be
of benefit to the market as a whole, contributing to the efficient
functioning of the securities
[[Page 11541]]
markets and the price discovery process.\128\
---------------------------------------------------------------------------
\126\ See Original QCT Exemption, supra note 9, at 52830-52831.
\127\ Id.
\128\ See CBOE QCT Exemption, supra note 13, at 19273.
---------------------------------------------------------------------------
Thus, in light of the benefits provided by both the requirement for
exposure as well as by qualified contingent trades such as QCC Orders,
the Commission must weigh the relative merits of both for the options
markets.\129\ The Commission believes that the proposal, in requiring a
QCC Order to be: (1) Part of a qualified contingent trade under
Regulation NMS; (2) for at least 1,000 contracts; (3) executed at a
price at or between the national best bid or offer; and (4) cancelled
if there is a Priority Customer Order on ISE's limit order book,
strikes an appropriate balance for the options market in that it is
narrowly drawn \130\ and establishes a limited exception to the general
principle of exposure and retains the general principle of customer
priority in the options markets. Furthermore, not only must a QCC Order
be part of a qualified contingent trade by satisfying each of the six
underlying requirements of the NMS QCT Exemption, the requirement that
a QCC Order be for a minimum size of 1,000 contracts provides another
limit to its use by ensuring only transactions of significant size may
avail themselves of this order type.\131\
---------------------------------------------------------------------------
\129\ The Commission notes that it has previously permitted the
crossing of two public customer orders, for which no exposure is
required on ISE and CBOE. See CBOE Rule 6.74A.09 and ISE Rules
715(i) and 721.
\130\ The Commission notes that, in its request to remove the
block-size requirement of the Original QCT Exemption, CBOE stated
that the NMS QCT Exemption's other requirements would ensure that
the exemption was narrowly drawn and limited to a small number of
transactions. See Letter, dated November 28, 2007, from Edward J.
Joyce, President and Chief Operating Officer, CBOE, to Nancy M.
Morris, Secretary, Commission, at 1, 4.
\131\ The Commission notes that the requirement that clean
crosses be of a certain minimum size is not unique to the QCC Order.
See, e.g., NSX Rule 11.12(d), which requires, among other things,
that a Clean Cross be for at least 5,000 shares and have an
aggregate value of at least $100,000.
---------------------------------------------------------------------------
As noted above, some commenters argue that the concerns regarding
the impact of the QCC Order on the incentives for liquidity providers
are heightened by the events of May 6, 2010.\132\ Specifically,
commenters argued that in light of the events of May 6, 2010, the
Commission should not improve measures that would create disincentives
for market makers to provide liquidity to the markets.\133\ The
Commission recognizes the important role liquidity providers play,
particularly in the options markets, which tend to be more quote driven
than the cash equities markets. In addition, the Commission is
cognizant of the concerns raised by some commenters with regard to the
events of May 6, 2010. However, as discussed above, the Commission has
weighed the relative merits of the QCC Order and of the exposure of
such orders and believes that ISE's proposal is consistent with the
Act.
---------------------------------------------------------------------------
\132\ See supra notes 83-84 and accompanying text.
\133\ Id.
---------------------------------------------------------------------------
C. Customer Protection
In response to concerns that the Original QCC Order did not provide
adequate customer protection because the QCC Order would have priority
over resting customer orders on ISE's books,\134\ ISE proposes to
modify the QCC Order to provide for automatic cancellation of a QCC
Order if there is a Priority Customer order on the Exchange's limit
order book at the same price. The Commission believes that this
modification to yield to a Priority Customer order on the book would
ensure that QCC Orders do not trade ahead of Priority Customer orders
at the same price, and thus should alleviate commenters' concerns
regarding the Original QCC Order that customers would not receive
executions of their resting orders, which could also create a
disincentive to placing limit orders.
---------------------------------------------------------------------------
\134\ See Petition for Review, supra note 22, at 15, 17. See
also Bluefin Statement, supra note 29; Phlx Letter, supra note 26;
Wolverine Letter, supra note 26; Group One Letter, supra note 26, at
1; and Integral Derivatives Letter, supra note 26.
---------------------------------------------------------------------------
Some commenters objected to the Modified QCC Order because they
believed that a customer order submitted as a QCC Order risks receiving
a fill at an inferior price to the price it could have received if it
has been exposed to the market.\135\ Another commenter was concerned
that, while the option trade would be within the NBBO, the stock trade
may be priced outside of the market and that ``[t]he effect is a
valuation for the stock/option package * * * unrestricted by
competition * * * . '' \136\ In response to commenters concerns
regarding price improvement, ISE argued that the actual execution price
of each component is not as material to the parties as is the net price
of the transaction and accordingly, price improvement of the individual
legs of the trade is not a critical issue in executing the QCC
Order.\137\
---------------------------------------------------------------------------
\135\ See Group One Letter 2, supra note 4, at 1; and CBOE
Letter 1, supra note 4, at 2.
\136\ See LiquidPoint Letter 2, supra note 4, at 2.
\137\ See supra note 103 and accompanying text.
---------------------------------------------------------------------------
As discussed above, QCC Orders must be for 1,000 or more contracts,
in addition to meeting all of the requirements of the NMS QCT
Exemption. The Commission believes that those customers participating
in QCC Orders will likely be sophisticated investors who should
understand that, without a requirement of exposure for QCC Orders,
their order would not be given an opportunity for price improvement on
the Exchange. These customers should be able to assess whether the net
prices they are receiving for their QCC Order are competitive, and who
will have the ability to choose among broker-dealers if they believe
the net price one broker-dealer provides is not competitive. Further,
broker-dealers are subject to a duty of best execution for their
customers' orders, and that duty does not change for QCC Orders.
IV. Conclusion
In sum, the Commission believes that ISE's Modified QCC Order is
consistent with the NMS QCT Exemption, which found that qualified
contingent trades are of benefit to the market as a whole and a
contribution to the efficient functioning of the securities markets and
the price discovery process.\138\ In addition, the Exchange's Modified
QCC Order is narrowly drawn to provide a limited exception to the
general principle of exposure, and retains the general principle of
customer priority. Accordingly, the Commission finds that the proposed
rule change is consistent with the requirements of the Act and the
rules and regulations thereunder applicable to a national securities
exchange and, in particular, with Section 6(b) of the Act.\139\
Specifically, the Commission finds that the proposal is consistent with
Sections 6(b)(5) \140\ and 6(b)(8) of the Act.\141\ Further, the
Commission finds that the proposed rule change is consistent with
Section 11A(a)(1)(C) of the Act.\142\
---------------------------------------------------------------------------
\138\ See supra note 13.
\139\ 15 U.S.C. 78f(b). In approving this proposed rule change,
the Commission has considered the proposed rule's impact on
efficiency, competition, and capital formation. See 15 U.S.C.
78c(f).
\140\ 15 U.S.C. 78f(b)(5).
\141\ 15 U.S.C. 78f(b)(8).
\142\ 15 U.S.C. 78k-1(a)(1)(C).
---------------------------------------------------------------------------
It is therefore ordered, the proposed rule change (SR-ISE-2010-73)
is approved pursuant to Section 19(b)(2) of the Act.\143\
---------------------------------------------------------------------------
\143\ 15 U.S.C. 78s(b)(2).
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-4574 Filed 3-1-11; 8:45 am]
BILLING CODE 8011-01-P