THE TIMBER HILL GROUP
TWO PICKWICK PLAZA
July 16, 1999
VIA FEDERAL EXPRESS
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Application for Registration as a National Securities Exchange
Filed by International Securities Exchange, File No. 10-127
Dear Mr. Katz:
On behalf of the Timber Hill Group, I am writing to comment upon the application by the International Securities Exchange to register with the Commission as a national securities exchange pursuant to Section 6 of the Securities Exchange Act of 1934.
The Timber Hill Group includes Timber Hill LLC, Interactive Brokers LLC and other affiliates which, through the use of our proprietary communications technology, trade standardized derivative investment products on organized securities and futures exchanges worldwide. Timber Hill LLC is registered with the Commission as a broker-dealer and is a member in good standing of the Chicago Board Options Exchange, American Stock Exchange, National Association of Securities Dealers, Philadelphia Stock Exchange and Pacific Exchange. Timber Hill LLC serves as an approved market maker, registered options trader or specialist in approximately 450 classes of option contracts traded in approximately 110 trading crowds. Interactive Brokers LLC, also a registered broker-dealer, engages exclusively in agency trading. It is a member in good standing of the Chicago Board Options Exchange, American Stock Exchange and Philadelphia Stock Exchange, where it offers execution of customer orders in all option classes.
An active participant in all of the major organized auction markets for derivative investment products, the Timber Hill Group (hereafter "Timber Hill") will likely participate in the new International Securities Exchange ("ISE"), in a manner and to a degree not yet determined, in the event ISEís application for registration is approved by the Commission. Further, as the Commission is aware from prior comment letters and other public pronouncements, Timber Hill is committed to the development and deployment of new technologies to enhance market efficiency and to promote lively and fair competition among markets and market participants. For these reasons, Timber Hill has decided to share with the Commission its thoughts and concerns regarding the ISEís proposed trading rules.
Timber Hill commends ISE for creating the first entirely electronic exchange for the trading of standardized derivative products. In Timber Hillís view, an electronic exchange could significantly enhance the speed, accuracy, orderliness and overall efficiency of derivatives trading. These are precisely the benefits that Congress had in mind when it directed the Commission in 1975 to use its statutory authority to promote the use of new data processing and communications techniques and thereby facilitate the economically efficient execution of securities transactions. 15 U.S.C. Section 78k-1(a). In short, Timber Hill supports the establishment of an electronic exchange for the trading of securities options.
Timber Hill believes the ISE would fulfill its pioneering role even more fully using a somewhat different structure that allows easier entry for different classes of market participants and imposes fewer restraints on competition. Ideally, the proposed rules should be carefully tailored so that all members are provided with equal rights and obligations so that they may participate on the even playing field envisioned by Congress, and so that the investing public may achieve equivalent benefits. Thus, three principles should guide the Commissionís review of the proposed rules: (i) all exchange members should have equal rights and obligations unless the exchange meets a substantial burden of establishing that variances are in the best interests of the general investing public; (ii) all electronic messages received by the exchange should be handled in the order in which they are received; and (iii) all orders should be entitled to interact with each other on an equal playing field and be required to stand as firm until canceled. With these principles in the forefront, the Commission has a unique opportunity to sanction an ideal exchange, particularly since the technology is available to assure the goals of these principles will be realized.
With respect to our General Comments, Timber Hill emphasizes its fears that ISEís proposed Rule 804(d)(2), the trade or fade provision, may invite deceptive conduct and give rise to market manipulation. Timber Hill hopes that these issues may be resolved quickly by ISE, before the Commission rules upon the pending application, so that the investment community will not be denied the immediate advantages of fully electronic options trading.
Barriers to Entry and Unnecessary Restraints Upon Competition
Timber Hillís principal concern with ISEís proposed structure is that it erects barriers to entry and other impediments to competition for which there is no offsetting regulatory benefit. The most obvious and most formidable barrier to entry is the tight limit ISE proposes to place upon the number of market makers who will be appointed to each option class traded on the exchange. ISE plans to appoint only one Primary Market Maker and as few as two Competitive Market Makers to each class of options, regardless of volume. See Rule 802(c). Considering that some of the options ISE intends to list are presently traded in crowds populated by as many as 100 or more market makers, we naturally wonder why ISEís auction market must be so restrictive.
Increasing the number of market makers in each crowd would not only yield tighter markets, but also reduce the cost of an ISE market maker membership, another significant barrier to entry. At present, the enormous profit potential associated with serving as one of only three market makers in an actively traded option class has likely boosted the price of market maker memberships in ISE to levels far higher than, perhaps multiples of, the prices paid for memberships at the existing options exchanges. These enormous membership prices operate to exclude many experienced, capable and competitive market makers from participating in ISE.
Opening ISE to more market makers would be one way of enhancing quote competition. Another would be to eliminate or reduce some of the restraints ISEís rules impose upon its members. Rule 805(b)(2) prohibits a CMM from trading more than 25% of its volume in any calendar quarter in option classes in which it does not hold an appointment. While similar volume restriction rules in operation serve a necessary purpose, namely, to ensure that market makers on open outcry exchanges are physically present in the specific trading crowds to which they are assigned to fulfill their obligation to make markets, the same is not true at an electronic exchange, where a market makerís physical presence is not necessary for the market maker to make bids and offers. On the ISE, if the current technology permits a CMM to make markets in 60 classes simultaneously, there is no reason the market maker should not be able to make markets in many more, subject only to the requirement that the CMM fulfill its duties in its appointed class.
Rule 717(b) acts as an even more serious brake on competition: It prohibits Electronic Access Members ("EAMs") from entering two-sided limit orders into ISEís system, either as principal or as agent, on a sufficiently regular or continuous basis as to constitute market making. Rule 717(b) was apparently patterned after rules recently adopted by the CBOE and the Pacific Exchange that prohibit floor brokers from using hand-held communications devices on the trading floor to "perform a market-making function." Timber Hill filed comment letters objecting to the CBOE and PSE rules on the grounds, among others, that they were anti-competitive, discriminatory and injurious to the investing public. Acknowledging Timber Hillís objections, the Commission nevertheless approved the rules as a valid exercise of the discretion accorded CBOE and PSE as self-regulatory organizations under Section 6 of the Exchange Act. See SEC Rel. No. 34-38054 (Dec. 16, 1996) (approving SR-CBOE-95-48); SEC Rel. No. 34-40577 (approving SR-PSE-97-02). The CBOEís reasoning was that off-floor market making would entice on-floor market makers to leave the floor and move upstairs which would change the "ecology of the floor".
Timber Hill continues to believe that no valid regulatory purpose is served by prohibiting persons other than exchange-approved market makers from improving the prevailing bid-ask differential in a listed security on a regular or continuous basis by means of two-sided limit orders. Timber Hill also believes that the regulatory costs and benefits likely to result from an exchangeís prohibition of so-called "off-floor market making" must be analyzed on an exchange-by-exchange, if not crowd-by-crowd, basis. Accordingly, Timber Hill recommends that the Commission either disapprove ISE Rule 717(b) altogether or, at a minimum, conduct fact-finding to determine whether a prohibition against market making by EAMs is reasonably necessary to protect the competitive market maker system contemplated by ISE. Of course, at any such hearing ISE should, as required by the National Securities Markets Improvement Act of 1996, bear the burden of proving that less restrictive measures would not adequately protect its marketplace. (We note, by way of comparison, that European electronic exchanges encourage market makers by charging them lower transaction fees rather than giving them monopoly rights by foreclosing others from making two sided markets.) For the reasons which follow, we think this is a burden ISE would not likely meet.
Under ISEís rules, CMMs are guaranteed special privileges not available to market makers on any other derivatives exchange, including: (i) severe restrictions upon the number of market makers who will be allowed to compete in each trading "group"; (ii) the opportunity to make markets in as many as 60 different options classes at the same time; and (iii) the right to participate in all trades within the group that exceed a prescribed minimum size. In light of these uniquely generous benefits, it is extremely unlikely that the threat of competitive market making by EAMs, whose numbers are not limited and whose participation rights are subordinate to the CMMsí, will keep CMMs from joining or remaining members of the ISE. Moreover, in an auction market in which as few as two CMMs might be responsible for continuously quoting markets "10-up" in 60 different option classes, we believe that the ISE should be encouraging supplementary market making by EAMs, not suppressing it.
Rule 804(d)(2): Trade or Fade
Proposed Rule 804(d)(2), which ironically is listed under the heading "Firm Quotes," replicates the so-called "trade or fade" rules that were adopted by the other options exchanges and approved by the Commission in July 1994. See CBOE Rule 8.51(b), PHLX Rule 1015(b), Amex Rule 958A (and Commentary .01), and PSE Rule 6.37. These rules provide that when a market maker or trading crowd is confronted with a marketable limit order from a registered broker-dealer, the market maker or crowd may disavow its published quotes and "fade" to lower bids or higher offers in order to avoid filling the order. "Trade or fade" rules thus expressly authorize the dissemination of what the industry refers to as "phantom" quotations; bids and offers that appear on the screen but are not available to be acted upon by all market participants.
Timber Hill believes that published bids and offers are sacrosanct, that phantom quotes have no place in a national market system for securities, and that exchange rules that expressly authorize a market maker or trading crowd to refuse to honor its quotes undermine the integrity of the marketplace. Timber Hill also believes that a "trade or fade" rule is particularly unnecessary and inappropriate in the context of the unique trading system contemplated by ISE. For these reasons, Timber Hill objects to proposed ISE Rule 804(d)(2).
In our view, a published quotation is both an affirmative representation that the quoting party is ready, willing and able to purchase or sell a listed security and an invitation to trade at the quoted price. Phantom quotes are neither. They are conditional solicitations that may or may not result in trades depending upon the status of the party who responds to the solicitation. In this respect, phantom quotes are like "bait and switch" advertising tactics: Both create the illusion of trading opportunities that in fact do not exist.
Phantom quotes exaggerate the true buying and selling interest for a quoted security. They thereby make the markets less transparent and distort the price discovery mechanism. Indeed, phantom quotes may have a surprisingly disproportionate impact upon price discovery because their impact is limited to the constituency that is the most sensitive to minor fluctuations in an optionís price and the most interested in published prices that genuinely reflect supply and demand, namely, broker-dealers. Public customers on the other hand, the only constituency that may hold a market maker to his published quotes, are less likely to be sensitive to minor short-term fluctuations in the price of an option and thus less likely to respond to quotes in a way that would contribute meaningfully to price discovery.
A corollary of the point expressed above is that phantom quotes invite market manipulation. Whenever a market maker is permitted to disseminate a quote that is not binding, he naturally will be more susceptible to the temptation to use the quote process for ulterior purposes -- for example, to move the settlement price of an option so as to reduce his net capital requirement. We are not so naïve as to think that holding market makers to their disseminated quotes would eliminate the problem of marking, but at least there would be a cost associated with it. Common sense suggests that marking is much more likely in a trading environment that tolerates and condones phantom quotes.
In addition to being inherently deceptive, phantom quotes disrupt the smooth functioning of the market and make it less efficient. Whenever a disseminated quote is "faded" in response to an otherwise marketable broker-dealer order, additional communications between the affected broker-dealer and the crowd will be required for the broker-dealer to obtain a fill. Even in an entirely electronic marketplace, the time and expense associated with this iterative process represent unnecessary drags upon the marketís efficiency.
The deceptions and distortions caused by phantom quotes are likely to be particularly serious at the ISE. This is because the ISE proposes to tally and display to members the aggregate size of all orders and quotes entered into the system at the best bid and offer ("BBO"). The aggregate size at the BBO is information that undoubtedly will be processed by market participants in assessing the market for the subject security and deciding whether and how much to purchase or sell at the posted price. Yet none of the size disseminated on either side of ISEís markets may be available to satisfy broker-dealer orders. To broker-dealers, the market participants most likely to trade in size, ISEís posted size could prove to be entirely illusory.
When the options exchanges first proposed their "trade or fade" rules to the Commission, they jointly represented that the rules were necessary to minimize "trade-throughs" in multiply listed options. A trade-through occurs when an order is filled at one exchange at a price that is inferior to the price available elsewhere. According to the exchanges, trade-throughs were occurring, not because better prices were in fact available at another exchange, but merely because the competing exchange had allowed its disseminated quotes to grow stale. See generally SEC Rel. No. 34-34431, 1994 SEC LEXIS 2322 . "Trade or fade" rules, the exchanges represented, would "assure that a competing exchangeís disseminated price is in fact the best price at which a trade can be effected . . . . " 1994 SEC LEXIS 2322 at *10.
Significantly, at the time the "trade or fade" rules were under consideration, none of the exchanges proposed extending the "fade" alternative to orders originating with public customers, as opposed to broker-dealers. For customer orders, the exchanges insisted that their trading crowds "trade" at its disseminated quotes, at least up to 10 contracts. The exchanges justified their disparate treatment of customer and broker-dealer orders on the grounds that exchange specialists were "understandably reluctant" to stand behind their quotes for broker-dealer orders because a broker-dealer, unlike a public customer, might succeed in entering an order before the specialist had "sufficient time within which to adjust quotes to reflect changes in the markets underlying [his] options." Id. at *3, *6.
Within the entirely electronic trading system proposed by ISE, it is difficult to see how ISE market makers would ever be at an informational disadvantage to others in the marketplace. Both Primary Market Makers ("PMMs") and Competing Market Makers ("CMMs") will have immediate access to all information about the underlying security and will have electronic facilities to automatically update their quotes in response. Moreover, unlike other market participants PMMs will have access to information about every option order and quote that has been entered into the ISE system, making them even less susceptible of being disadvantaged by non-member traders with superior market intelligence. For this reason also, the Commission should not approve ISEís proposed "trade or fade" rule, Rule 804(d)(2).
We have one final observation. By disabling broker-dealers from acting on market makersí displayed quotes, the trade or fade rule creates a strong disincentive for broker-dealers to engage in proprietary trading on the ISE. Similarly, the prohibition on market making by EAMs, which we have already discussed, will discourage broker-dealers from routing professional orders to the ISE. With these two rules operating in concert, the ISE runs the unintended risk of serving, not as a true exchange, but merely as a means by which a few members may internalize their own order flow in a noncompetitive environment, matching (but not improving upon) bids and offers displayed in other market centers. The consequent diversion of retail order flow to the ISE, in turn, could weaken the other, more competitively priced exchanges, and lead them to develop even more restrictive rules on proprietary and agency trading by broker-dealers. The end result could well be a national market system that, in times of market stress, provides inadequate facilities for the liquidation of deficit customer accounts and the hedging or movement out of unwanted proprietary positions.
We are grateful for the opportunity to express our views on ISEís proposed trading rules. We believe that the resolution of our concerns and the opening of trading on ISE will significantly enhance the efficiency of our markets, and we commend ISEís efforts to achieve this goal.
cc:Hon. Arthur Levitt
Hon. Isaac C. Hunt, Jr.
Hon. Norman Johnson
Hon. Paul R. Carey
Hon. Laura Simone Unger
Annette L. Nazareth, Esq.
Michael Walinskas, Esq.
Sheila Slevin, Esq.
Christine Richardson, Esq.
Joseph Morra, Esq.