SIG Indices, LLLP
June 30, 2003
Jonathan G. Katz, Secretary
Re: Rule-Making Petition on Index Options by the International Securities Exchange, Inc. (Commission File Number 4-469).
Dear Mr. Katz:
SIG Indices, LLLP ("SIG") appreciates this opportunity to comment on the rule-making petition by the International Securities Exchange, Inc. (the "ISE") relating to licensing arrangements with respect to index options (the "Rule-Making Petition"). SIG is a developer, licensor and provider of securities indices. In addition, affiliates of SIG act as specialists and market makers for options (including index options) and exchange traded funds on all of the United States options exchanges. Accordingly, SIG would be impacted greatly in the event that the Commission adopts the amendments (the "Amendments") to Rule 19c-5 under the Securities Exchange Act of 1934, as amended, which are proposed in the Rule-Making Petition.
In general, the Rule-Making Petition requests that the Commission adopt the Amendments so as to prohibit an options exchange from being a party to exclusive or preferential licensing arrangements with respect to index option products and options overlying other instruments, including options on securities whose value is based on an index. The ISE submits that "prohibiting such license arrangements will enhance competition in the market and will result in significant benefits for the investing public." For the reasons stated below, SIG respectfully submits that the Commission should not adopt the Amendments as the Amendments will not have this stated effect and, in fact, are likely to have the opposite effect, and will vitiate index providers' legitimate rights in their intellectual property.
Index providers invest significant time, personnel, capital and other resources to develop products that they hope will meet a need within the investment community and thereby become a successful product. In some cases, these products are highly successful and become of enormous benefit to investors on a long term basis. However, most products fail to generate a reasonable return for the index provider. Even a product that fills a vital role for investors will often lose favor and not sustain its profitability for the index provider over the long term, since the "hot" sector is traditionally a fast moving and ever changing target. The unfortunate fact for index providers is that the development and maintenance costs for its products are continuous, while trading often is not. Consequently, to account for the expense of being in the business of creating and maintaining such products, index providers obtain trademark or service mark registrations of their indices and seek to license their indices in a manner designed to enhance the return on the successful investment products that they develop. In the case of license arrangements involving option exchanges, index providers have most often determined that a reasonable return on their investment is jeopardized by market fragmentation. This has led to the practice of granting one options exchange the exclusive right with respect to options based on the index.
In addition, in some instances, exchanges themselves have developed their own index products (e.g., the Semiconductor Index (SOX), which was developed by the Philadelphia Stock Exchange). The exchanges then protect their ideas by obtaining intellectual property rights in their indices and recoup their costs and generate income by serving as the exclusive trading site for their index option products.
The Amendments advanced by the Rule-Making Petition, however, would require index providers to enter into licensing arrangements that provide the same terms and conditions for all options exchanges. Thus, the Amendments are not only designed to unfairly prevent index providers from achieving a reasonable return on their investment, but they would effectively prevent index providers from earning any profits at all.
If an index provider were to develop a new index and was required to reach a licensing agreement with either all or none of the options exchanges to trade options on the index, the index provider would have no bargaining power whatsoever vis a vis the exchanges. The options exchanges, knowing that they must all receive the same license terms, will not have any incentive to pay an index provider any more than any other exchange. Instead, the options exchanges will effectively be forced into a cartel-like arrangement whereby they will naturally seek to have the lowest possible license fee apply to each of them. Needless to say, index providers will quickly question the wisdom of making the investments necessary to develop a successful index product in order to achieve limited rewards, if any. Moreover, with index providers unwilling to develop new products, the ultimate beneficiaries of their new products, the investing public, will sustain the greatest loss by not achieving the benefits associated with the development of new index products.
The protection of index providers' intellectual property should not be afforded any less protection than the intellectual property possessed by any other party, including the ISE. The ISE asserts in the Rule-Making Petition that it and the other options exchanges have improved technology and the services that they offer. Certainly, each of the options exchanges could posit a compelling argument that competition in the market would also be enhanced and significant benefits to the investing public would also result if the ISE or any other exchange were forced to share its technology with all of the other options exchanges. If the Commission agrees with the ISE regarding index licenses, then the Commission should certainly apply the same reasoning to innovative technology. In which case, the ISE (and all other options exchanges) would immediately lose all incentives to develop better technology (that would also benefit its competitors), resulting in stagnant exchange technology to the detriment of the investing public. On the other hand, if the Commission adopts the Amendments as to index licenses, but not as to innovative technology, then an exchange would be punished because it decided to commit its intellectual capital to developing indices rather than technology.
Finally, options exchanges have received significant support from their specialist firms in developing products based on licensed indices. In addition to their investments of personnel and capital to promote the index products for which they serve as specialist, specialist firms often contribute a significant portion of the exclusive license fees payable by the exchanges to the index provider. In most cases, the specialist firms have made significant investments to promote their index products. The Amendments would enable newly designated specialists on the other options exchanges to free ride on this significant investment. Put simply, this would be unfair to the original specialist firms.
In conclusion, notwithstanding the ISE's assurances that the "intent [of the Amendments] is not to harm index providers or limit their ability to achieve a fair return for their development of an index", this result is destined to occur if the Commission adopts the Amendments. More importantly, for the reasons stated above, the investing public will ultimately suffer instead of benefit by the adoption of the Amendments. Accordingly, SIG respectfully requests that the Commission decline to adopt the Amendments.
Thank you for your consideration.
cc: Annette Nazareth, Director, Division of Market Regulation