[Federal Register Volume 76, Number 60 (Tuesday, March 29, 2011)]
[Notices]
[Pages 17466-17468]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-7285]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-64115; File No. SR-ISE-2006-01]
Self-Regulatory Organizations; International Securities Exchange,
Inc. (n/k/a the International Securities Exchange, LLC); Order
Approving a Proposed Rule Change To Amend Exchange Rule Governing
Directed Orders
March 23, 2011.
I. Introduction
On January 5, 2006, the International Securities Exchange, Inc. (n/
k/a 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
proposal to amend ISE Rule 811 to allow the identity of a firm entering
a Directed Order to be disclosed to a Directed Market Maker (``DMM'').
The proposed rule change was published for comment in the Federal
Register on January 19, 2006.\3\ The Commission received comment
letters from the Interactive Brokers Group supporting the proposal, and
from Citadel opposing the proposal.\4\ This order approves the proposed
rule change.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 53103 (January 11,
2006), 71 FR 3144.
\4\ See letters to Nancy M. Morris, Secretary, Commission, from
Thomas Peterffy, Chairman, and David M. Battan, Vice President,
Interactive Brokers Group, dated February 10, 2006 (``IB Letter'')
and Adam C. Cooper, Senior Managing Director & General Counsel,
Citadel, dated February 27, 2006 (``Citadel Letter''), incorporating
by reference a letter from Adam C. Cooper, Senior Managing Director
& General Counsel, Citadel, dated January 11, 2006 (``Citadel Letter
II'').
In reviewing this proposed rule change, the Commission also
considered a comment letter by the American Stock Exchange in
response to a proposed rule change submitted by the ISE to amend ISE
Rule 811 to allow the identity of a firm entering a Directed Order
to be disclosed to a DMM on a temporary basis, which became
immediately effective upon filing with the Commission. See
Securities Exchange Act Release No. 53104 (January 11, 2006), 71 FR
3142 January 19, 2006 (SR-ISE-2006-02). See also letter to Nancy M.
Morris, Secretary, Commission, from Neal L. Wolkoff, Chairman &
Chief Executive Officer, American Stock Exchange, dated February 3,
2006 (``Amex Letter'') and February 7, 2006 (``Amex Letter II'').
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II. Description of the Proposal
The Exchange currently operates a Directed Order system in which
Electronic Access Members (``EAMs'') can send an order to a DMM for
possible price improvement.\5\ If a DMM accepts Directed Orders
generally, that DMM must accept all Directed Orders from all EAMs. Once
such a DMM receives a Directed Order, it either (i) must enter the
order into the Exchange's Price Improvement Mechanism (``PIM'') auction
and guarantee its execution at a price better than the ISE best bid or
offer (``ISE BBO'') by at least a penny and equal to or better than the
National Best Bid and Offer (``NBBO'') \6\ or (ii) must release the
order into the Exchange's limit order book, in which case there are
certain restrictions on the DMM interacting with the order.
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\5\ See Securities Exchange Act Release No. 52331 (August 24,
2005), 70 FR 51856 (August 31, 2005) (SR-ISE-2004-16).
\6\ See ISE Rule 723.
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On January 5, 2006, ISE filed a proposed rule change, which became
immediately effective upon filing with the Commission, to alter its
existing Directed Order system on a temporary basis so that the system
would disclose the identity of the firm entering a Directed Order to a
DMM.\7\ The rule permitting the ISE system to identify to DMMs the firm
from which a Directed Order originates continues to operate on a pilot
basis through May 31, 2011.\8\ ISE proposes in this filing to amend ISE
Rule 811 to permit the identity of an EAM that enters a Directed Order
to be made available to the DMM and thus to make permanent its rule
change that has been operating on a pilot basis for the past five
years.
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\7\ See Securities Exchange Act Release No. 53104 (January 11,
2006), 71 FR 3142 (January 19, 2006) (rule change was effective
until June 30, 2006). The Commission received three comment letters
regarding the temporary system change. See IB Letter, Amex Letter,
and Amex Letter II, supra note 4.
\8\ See Securities Exchange Act Release Nos. 53104 (January 11,
2006), 71 FR 3142 January 19, 2006 (SR-ISE-2006-02); 54083 (June 30,
2006), 71 FR 38920 (July 10, 2006) (SR-ISE-2006-35); 54542
(September 29, 2006), 71 FR 59170 (October 6, 2006) (SR-ISE-2006-
57); 55144 (January 22, 2007), 72 FR 3890 (January 26, 2007) (SR-
ISE-2007-05); 56155 (July 27, 2007), 72 FR 43306 (August 3, 2007)
(SR-ISE-2007-67); 59176 (January 24, 2008), 73 FR 5615 (January 30,
2008) (SR-ISE-2008-08); 59276 (January 22, 2009), 74 FR 5007
(January 28, 2009) (SR-ISE-2009-02); 59943 (May 20, 2009), 74 FR
25296 (May 27, 2009) (SR-ISE-2009-28); 60956 (November 6, 2009), 74
FR 58674 (November 13, 2009) (SR-ISE-2009-93); and 63357 (November
22, 2010), 75 FR 73144 (November 29, 2010) (SR-ISE-2010-110).
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III. Discussion
After careful review of the proposal and of the comment letters,
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 \9\ and, in
[[Page 17467]]
particular, the requirements of Section 6 of the Act.\10\ Specifically,
as discussed below, the Commission finds that the proposed rule change
is consistent with Section 6(b)(5) of the Act,\11\ which requires,
among other things, that the rules of a national securities exchange be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to foster cooperation
and coordination with persons engaged in regulating, clearing,
settling, and processing information with respect to, and facilitating
transactions in securities, 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 are not
designed to permit unfair discrimination among customers, issuers,
brokers, or dealers.
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\9\ Citadel argues that this proposal facilitates anti-
competitive behavior and therefore violates Section 3(f) of the Act.
See Citadel Letter II, supra note 4, at 6. Section 3(f) of the Act
requires the Commission to consider or determine whether this
proposed rule change is necessary or appropriate in the public
interest and, in addition to the protection of investors, will
promote efficiency, competition, and capital formation. In approving
this proposed rule change, the Commission has considered the
proposed rule's impact on efficiency, competition, and capital
formation. As discussed below, the Commission does not believe the
proposal is anti-competitive. 15 U.S.C. 78c(f).
\10\ 15 U.S.C. 78f.
\11\ 15 U.S.C. 78f(b)(5).
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A. Proposal is Not Unfairly Discriminatory
Under the proposal, the ISE system would provide the identity of an
EAM that enters a Directed Order to the DMM to whom the order is
directed. Citadel argues that the lack of anonymity of Directed Orders
allows the DMM receiving such orders to discriminate in its
determination regarding for which orders the DMM would provide an
opportunity for price improvement through the ISE's PIM auction.\12\
The principal criticism of ISE's proposal is that it is inconsistent
with the requirement in Section 6(b)(5) of the Act that the rules of an
exchange not be ``designed to permit unfair discrimination between
customers, issuers, brokers, or dealers.'' \13\ Section 6(b)(5) of the
Act prohibits an exchange from establishing rules that treat these
market participants in an unfairly discriminatory manner. Section
6(b)(5) of the Act does not prohibit exchange members or other broker-
dealers from discriminating, so long as their activities are otherwise
consistent with the Federal securities laws. Nor does Section 6(b)(5)
of the Act require exchanges to preclude discrimination by broker-
dealers. Broker-dealers commonly differentiate between customers based
on the nature and profitability of their business.
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\12\ See Citadel Letter II, supra note 4, at 4-5.
\13\ 15 U.S.C. 78f(b)(5). See Citadel Letter II, supra note 4,
at 5; and Amex Letter, supra note 4, at 2.
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Currently under ISE's rules, an EAM may provide an opportunity for
price improvement to a customer order by submitting it to the PIM. An
EAM may decide who to accept as its customers and further choose to
provide an opportunity for price improvement to some customer orders,
but not others, by exercising discretion as to whether it chooses to
send a particular order to the PIM auction.\14\ An EAM would know the
identity of its customer in deciding whether to provide this
opportunity for price improvement. A DMM may also provide an
opportunity for price improvement to Directed Orders by submitting them
to the PIM. The proposed rule change would enable a DMM to consider the
identity of the EAM directing the order when deciding whether to
provide an opportunity for price improvement.\15\ Thus, the proposal
will provide information to DMMs that is the same information available
to other ISE members when they decide whether to provide price
improvement to a particular order.
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\14\ See also Chapter V, Section 18 of the Boston Options
Exchange Rules (Price Improvement Period) and Rule 6.74A of the
Chicago Board Options Exchange, Incorporated (Automated Improvement
Mechanism).
\15\ Specialists and other market makers may establish payment
for order flow relationships with firms on a discretionary basis. A
specialist or market maker may pay varying amounts for order flow
received from different firms or different customers within firms.
Unlike payment for order flow, which principally benefits
intermediaries and, indirectly, their customers through possibly
lower fees and better services, customers' orders executed through
the PIM auction directly benefit customers with the opportunity for
an improved price.
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While customer anonymity may be valuable in ensuring that broker-
dealers comply with legal obligations in a variety of circumstances,
such as market makers' firm quote obligations, customer anonymity is
not required of exchanges, particularly when disclosure of customer
identity could provide benefits to certain customers beyond those
required by the Federal securities laws or exchange rules. In
particular, market makers may be willing to offer better execution
prices to certain customers' orders (e.g., retail customers' orders).
The Commission does not believe that it would be inconsistent with the
Federal securities laws for the Exchange to provide, under the
circumstances set forth in this proposal, the means for DMMs to
differentiate between customers in providing price improvement or other
non-required advantages to certain customers. The Exchange's proposal
treats all DMMs the same and establishes no requirements for which
orders a DMM chooses to provide an opportunity for price improvement.
The Commission does not believe that the absence of Exchange rules
specifying which orders a DMM may execute at prices better that its
public quote is unfairly discriminatory.
Accordingly, while the proposal would permit a DMM to discriminate
among customers in providing prices better than its quote, the
Commission does not believe that this discrimination is inconsistent
with Section 6(b)(5) of the Act.
B. Impact of Proposal on Market Quality and Competition
Citadel argues that the proposal would discourage aggressive
quoting and would be detrimental to price improvement.\16\ The
Commission has considered this comment and does not believe that the
rule change proposed by ISE would discourage DMMs from quoting
aggressively. The Commission believes that a DMM has an incentive to
quote aggressively to gain priority with respect to orders entered on
the limit order book. Further, the Commission believes that the
commenter's argument that the proposal will harm market quality rests
on a number of premises that are unlikely to occur. The commenter
assumes that ISE's proposal will lead to less aggressive quoting across
all options exchanges and a widening of the NBBO. The Commission does
not believe that this will occur because there is rigorous competition
for order flow across options exchanges so any widening of quotes on
one market is an opportunity for another option market to capture order
flow.\17\ In fact, the Options Order Protection and Locked/Crossed
Market Plan provides protection from one exchange ignoring better
quoted prices on another market and will continue to promote quote
competition across options exchanges.\18\
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\16\ See Citadel Letter II, supra note 4, at 8-9.
\17\ See Robert Battalio, ``Third Market Broker-Dealers: Cost
Competitors or Cream Skimmers?'' Journal of Finance, 1997; and
Robert Battalio, Robert Jason Greene, and Robert Jennings, ``How Do
Competing Specialists and Preferencing Dealers Affect Market
Quality?'' Review of Financial Studies, 1997.
\18\ See Securities Exchange Act Release No. 60405 (July 30,
2009), 74 FR 39362 (August 6, 2009).
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In addition, allowing a DMM to know the identity of firms sending
Directed Orders may provide further incentive to that DMM to provide
price improvement. A DMM that receives a Directed Order would be
required to decide whether to send the order to the
[[Page 17468]]
PIM and guarantee a price better than the ISE BBO and equal to or
better than the NBBO to such order, or to release the order to the
book. The DMM's decision about whether to choose to guarantee a
particular order at a price better than the ISE BBO and equal to or
better than the NBBO may be affected by this proposal because it
provides DMMs with information to differentiate between orders from
informed traders (i.e., their competitors) and orders from uninformed
traders. It is well known in academic literature and industry practice
that prices tend to move against market makers after trades with
informed traders, often resulting in losses for market makers.\19\
Thus, there is a strong economic rationale for market makers not
providing informed traders price improvement. Uninformed investors end
up bearing the cost of these market maker losses through wider spreads
that market makers need to quote to uninformed investors due to
informed order flow.\20\
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\19\ See Stoll, H. R., ``The supply of dealer services in
securities of markets,'' Journal of Finance 33 (1978), at 1133-51;
Glosten, L. and P. Milgrom, ``Bid ask and transaction prices in a
specialist market with heterogeneously informed agents,'' Journal of
Financial Economics 14 (1985), at 71-100; and Copeland, T., and D.
Galai, ``Information effects on the bid-ask spread,'' Journal of
Finance 38 (1983), at 1457-69.
\20\ Id.
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Citadel also argues that the Commission has previously sought to
eliminate similar anti-competitive practices allowed by self-regulatory
organizations (``SROs'') involving lack of order anonymity.\21\ In
particular, Citadel cites a 1996 investigation of NASD and Nasdaq Stock
Market in which ``[s]ome market makers, without disclosure to their
customers, shared information with each other about their customers'
orders, including the size of the order and, on occasion, the identity
of the customer.'' \22\ Citadel asserts that the ``Commission concluded
that this anti-competitive behavior violated the antifraud provisions
of the Exchange Act, among other provisions.'' \23\
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\21\ See Citadel Letter II, supra note 4, at 6.
\22\ See Securities Exchange Act Release No. 37542 (August 8,
1996) (File No. 3-8919) (Report Pursuant to Section 21(a) of the
Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq
Market), at 5.
\23\ See Citadel Letter II, supra note 4, at 6.
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The Commission does not believe that the proposal will result in
market maker conduct like that in the NASD case, which found that
market makers were collaborating with other market participants against
the interests of their customers contrary to the fair dealing
obligations of market makers.\24\ Unlike the NASD case, the interests
of the DMM's customers are not harmed by this proposal because
information pertaining to a DMM's Directed Orders is not shared among
competing DMMs and all orders sent to ISE must be executed at a price
no worse than the NBBO.\25\
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\24\ See Securities Exchange Act Release No. 37542, supra note
22, at 59.
\25\ See ISE Rule 811(e).
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Finally, Amex contends that the proposal is anti-competitive
because providing the identity of an EAM to DMMs provides them with the
ability to enter into anti-competitive customer allocation
arrangements.\26\ Amex argues that if ISE Market Makers know the
identities of order flow providers, they could agree to allocate those
order flow providers among themselves and provide price improvement to
only those that each has been allocated.\27\ There is, however, no
evidence that customer allocation arrangements exist between Market
Makers. The Commission is today approving only the proposed rule
change, which permits a DMM to determine from which EAM it will accept
Directed Orders. The Commission is not approving any customer
allocation arrangements among Market Makers.
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\26\ See Amex Letter, supra note 4, at 2.
\27\ Id.
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For the foregoing reasons, the Commission finds that the proposed
rule change is consistent with the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular with Section 6(b)(5) of the Act.\28\
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\28\ 15 U.S.C. 78f(b)(5).
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IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\29\ that the proposed rule change (SR-ISE-2006-01) is approved.
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\29\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\30\
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\30\ 17 CFR 200.30-3(a)(12).
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Cathy H. Ahn,
Deputy Secretary.
[FR Doc. 2011-7285 Filed 3-28-11; 8:45 am]
BILLING CODE 8011-01-P