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U.S. Securities and Exchange Commission

Request for Rulemaking to Amend Rule 19c-5 Regarding Certain Options Exchange Licensing Arrangements

October November 1, 2002

Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Competition in the Options Markets; Petition for Rulemaking

Dear Mr. Katz:

The International Securities Exchange, Inc. ("ISE") petitions the Commission to amend Rule 19c-5 (the "Rule") under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), to remove the last bastion of anticompetitive listing practices in the options markets. Specifically, we request that the Commission adopt the attached amendments to the Rule 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. We believe that prohibiting such license arrangements will enhance competition in the market and will result in significant benefits for the investing public.

The Benefits of Multiple Trading

The Commission adopted the Rule in 1989, when there was only limited multiple trading. The lack of multiple trading was due both to (i) an "allocation plan" that permitted the options exchanges to list options on exchange-traded securities on an exclusive basis, and (ii) trading patterns that generally resulted in the trading of options on over-the-counter ("OTC") securities solely on the one exchange that captured the majority of the order flow, although not officially sanctioned by any rule.

The Rule prohibited the options exchanges from establishing any rule or practice limiting multiple trading. The Commission cited the following policy reasons for adopting this new regulation:

  • Market participants should be able to select the marketplace of their choice;
  • Multiple trading could lead to an improvement in market quality;
  • Investors could directly benefit from multiple trading by paying reduced transaction costs; and
  • Multiple trading, to the limited extent it then existed, had spurred options exchanges to offer enhanced services and to increase execution quality.

It took more than 10 years from the adoption of the Rule for the four then-existing options exchanges to engage in wide-scale multiple trading. This occurred only following the announcement in November of 1998 of our intent to register as an options exchange and to engage in multiple trading of the most-actively traded options. By August of 1999, all the remaining barriers to multiple trading had crumbled and open competition had begun in the options markets.

In reviewing the results of full-scale multiple trading, perhaps the only surprise is that the Commission actually underestimated the benefits of such trading. Competition over the last two years has resulted in fundamental and far-reaching changes to the options markets, all to the benefit of the investing public:

  • Reduced fees for customers: One of the most dramatic effects of multiple trading has been the changed economics in the industry. Prior to multiple trading, exchanges imposed significantly higher per-contract trading costs on customer orders than on market maker orders. With the advent of multiple trading the exchanges quickly eliminated all customer trading fees in competitively-traded products, while raising professional trading charges. The resulting savings allowed broker-dealers to discount commissions to investors, leading to significant savings.
  • Improved market quality: Increased competition has led to narrower quotation spreads. Our entry into the market also helped spur the growth of disseminating the size of quotations (discussed below), which in turn has led to competition to provide deeper markets for investors.
  • Improved market data: Prior to multiple trading, the Options Price Reporting Authority ("OPRA") disseminated non-firm quotations, without size, and was experiencing severe capacity constraints. Upon our announcement that we would be disseminating size, the other exchanges quickly established a priority that OPRA accommodate the dissemination of quotation size and increase its capacity. The Commission itself added the requirement that quotes be firm. In the two short years of multiple trading of options, market data has evolved from indicative, non-firm quotes of a single market, to competitive, firm quotes with size.
  • Technological enhancements: The 19c-5 Release noted that the limited multiple trading prior to adoption of the Rule had led the exchanges to improve technology and to enhance the services they offered. There have been even more dramatic changes since the beginning of full-scale multiple trading. Most importantly, multiple trading permitted our entry into the market, providing market participants with the first fully-electronic options exchange as an alternative to the floor-based exchanges. In turn, this gave rise to competing electronic trading alternatives, such as CBOEdirect. All options exchanges now are continuously reviewing their trading systems to offer members more convenient and attractive trading platforms.
  • Development of an Intermarket Linkage: A significant issue the Commission addressed when adopting the Rule was whether to condition multiple trading on the development of an intermarket linkage. The Commission ultimately determined to move forward with multiple trading notwithstanding the lack of a linkage. However, with the ultimate success of multiple trading, it soon became apparent that the options exchanges would need to take steps to help ensure that customers receive best execution of their orders. Thus, the Commission issued an order requiring the exchanges to develop a linkage, and the exchanges have moved steadily to implement that linkage.

The Need for Our Rule Proposal

There is one area in which there remains no multiple trading of options: the trading of index options and similar instruments. Rule 19c-5 does apply to index-based options, and no exchange has adopted a rule or procedure explicitly prohibiting multiple trading of these instruments. However, exclusive licensing arrangements have the same effect. Pursuant to these arrangements, an index developer will enter into an agreement with one exchange and grant that exchange the exclusive right to trade options based on the index. Often these arrangements are structured as licenses for the use of a trademark or service mark with respect to options.

To date, we are not aware of any Commission proceedings or court cases testing the legality of these arrangements. However, anyone attempting to list an index product for which it does not have a license is likely to face a strenuous legal challenge. Moreover, it is impractical even to list these products since The Options Clearing Corporation, the common issuing and clearing entity for standardized options, has told us it would not permit an exchange to list these types of products without a license for fear that it might incur liability.

This lack of competition directly affects investors. While no options exchange charges customers for transactions in equity options, exchanges continue to charge customer fees for trading index options. For example, the Chicago Board Options Exchange ("CBOE") imposes a transaction fee of $.20 per index option contract (other than on the S&P 100 and Mini-Nasdaq 100 indices) if the premium is a dollar or less, and a fee of $.40 per contract if the premium is more than one dollar. For the S&P 100, the fees are $.15 and $.30 per contract, respectively; for the Mini-Nasdaq 100 the fee is $.15 for all contracts. The CBOE also imposes additional index fees of: $.05 per contract as a "trade match" fee; $.04 per contract as a "floor brokerage fee"; and $.25 per contract as a "RAES fee." This results in fees that can reach $.70 per contract for automatic executions. For equity options, which are subject to multiple trading and competition, none of these fees apply. Competition would eliminate or greatly reduce these fees imposed on public customers.

In addition to the direct benefit that fee competition will provide, it is equally clear that enhanced competition will reduce spreads and provide investors with better executions. In adopting the Rule, the Commission cited two staff studies using data from the mid-1980's. One study showed that customers saved $25 million due to competition in options on OTC securities in a one-year period; the other study concluded that investors would receive a total savings of $150 million if multiple trading had been extended to all equity options. Since these studies were based on trading volumes now over 15 years old, it is likely that investors today would reap benefits multiple times that of the mid-1980's.

Our Proposed Rule Amendments

We propose two substantive changes to Rule 19c-5. First, immediately upon adoption of the rule amendments an exchange would not be permitted to enter into, or extend, any exclusive index licensing arrangement. Second, an exchange would be prohibited from being a party to any exclusive license arrangement after January 1, 2004. This would provide a transition period during which exchanges could continue operating under existing license agreements, but would not be permitted to extend them. It also would provide a period of time for exchanges and index providers to renegotiate existing licenses for operation in a multiple trading environment.

Our proposal is drafted broadly to address both direct licensing of a product and any similar arrangement where there is a license of a trademark or service mark. The prohibition would apply to index options and other similar products, including options on securities based on indices, such as exchange-traded funds ("ETFs"). The language would prohibit not only exclusive arrangements, but also preferential arrangements. This would require that any licensing agreement provide the same terms and conditions for all options exchanges.

In proposing these rule amendments, our intent is first to restrict, and then to prohibit, any type of contractual relationship that prevents multiple exchanges from licensing index and similar products on the same terms and conditions as are available to another exchange. Our intent is not to harm index providers or limit their ability to achieve a fair return for their development of an index. Rather, our intent is to eliminate a barrier to competition and to benefit investors. Indeed, we believe that enhancing competition in this market will result in increased trading of index and similar products, benefiting all participants in the options markets including the index providers.

* * *

We appreciate the opportunity the Commission provides interested persons to petition for changes to Commission rules. We urge the Commission to take prompt action to propose and adopt these rule amendments as quickly as possible so that investors may begin reaping the benefits of competition in the trading of index option products.

Yours very truly,

David Krell

President and Chief Executive Officer

cc: The HonorableChairman Harvey Pitt
Commissioner Cynthia Glassman
Commissioner Harvey Goldschmidt
Commissioner Paul Atkins
Commissioner Roel Campos
Annette Nazareth

 

Attachments:

  1. Draft of Proposed Amendments, Marked to Show Changes

  2. Draft of Proposed Amendments, Unmarked

Attachment 1

Proposed Amendment to Rule 19c-5 Marked to Show Changes from Current Rule

Underlining indicates additions; [brackets] indicate deletions.

240.19c-5. (a) The rules of each national securities exchange that provides a trading market in standardized put or call options shall provide as follows:

[(1) On and after January 22, 1990, but not before, no stated policy, practice, or interpretation of this exchange shall prohibit or condition, or be construed to prohibit or condition or otherwise limit, directly or indirectly, the ability of this exchange to list any stock options

class first listed on an exchange on or after January 22, 1990, because that options class is listed on another options exchange.]

[(2) During the period from January 22, 1990, to January 21, 1991, but not before, no stated policy, practice, or interpretation of this exchange shall prohibit or condition, or be construed to prohibit or condition or otherwise limit, directly or indirectly, the ability of this exchange to list up to ten classes of standardized stock options overlying exchange-list stocks that were listed on another options exchange before January 22, 1990. These ten classes shall be in addition to any options on an exchange-listed stock trading on this exchange that was traded on more than one options exchange before January 22, 1990.]

(1) [(3) On and after January 21, 1991, but not before, no] No stated policy, practice, or interpretation of this exchange shall prohibit or condition, or be construed to prohibit or condition or otherwise limit, directly or indirectly, the ability of this exchange to list any stock options class because that options class is listed on another options exchange.

(2) On or after {insert date of effectiveness of this paragraph}, but not before, no stated policy, practice or interpretation of this exchange shall permit this exchange to enter into or to extend a contractual or other relationship in which this exchange is granted an exclusive or preferential right or license (A) to issue standardized options overlying any instrument, index or other product, including options on securities based upon an index, or (B) to use any trademark, service market or similar right with respect to standardized options overlying any instrument, index or other product, including options on securities based upon an index.

(3) On or after January 1, 2004, but not before, no stated policy, practice or interpretation of this exchange shall permit this exchange to be a party to a contractual or other relationship in which this exchange is granted an exclusive or preferential right or license (A) to issue standardized options overlying any instrument, index or other product, including options on securities based upon an index, or (B) to use any trademark, service market or similar right with respect to standardized options overlying any instrument, index or other product, including options on securities based upon an index.

[(b) For purposes of paragraph (a)(2) of this Rule, if any options class is delisted from an options exchange as a result of a merger of the equity security underlying the option or a failure of the underlying security to satisfy that exchange's options listing standards, then the exchange is permitted to select a replacement option from among those standardized options overlying exchange-listed stocks that were listed on another options exchange before January 22, 1990.]

[(c)] (b) For purposes of this Rule, the term "exchange" shall mean a national securities exchange, registered as such with the Commission pursuant to Section 6 of the Securities Exchange Act of 1934, as amended.

[(d)] (c) For purposes of this the term "standardized option: shall have the same meaning as that term is defined in Rule 9b-1 under the Securities Exchange Act of 1934, as amended, 17 C.F.R. 240.9b-1.

[(e)] (d) For purposes of this Rule, the term "options class" shall have the same meaning as that term is defined in Rule 9b-1 under the Securities Exchange Act of 1934, as amended, 17 C.F.R. 240.9b-1.


Attachment 2

Rule 19c-5, as Proposed to be Amended (Unmarked)

240.19c-5. (a) The rules of each national securities exchange that provides a trading market in standardized put or call options shall provide as follows:

(1) No stated policy, practice, or interpretation of this exchange

shall prohibit or condition, or be construed to prohibit or condition or otherwise limit, directly or indirectly, the ability of this to list any stock options class because that options class is listed on another options exchange.

(2) On or after {insert date of effectiveness of this paragraph}, but not before, no stated policy, practice or interpretation of this exchange shall permit this exchange to enter into or to extend a contractual or other relationship in which this exchange is granted an exclusive or preferential right or license (A) to issue standardized options overlying any instrument, index or other product, including options on securities based upon an index, or (B) to use any trademark, service market or similar right with respect to standardized options overlying any instrument, index or other product, including options on securities based upon an index.

(3) On or after January 1, 2004, but not before, no stated policy, practice or interpretation of this exchange shall permit this exchange to be a party to a contractual or other relationship in which this exchange is granted an exclusive or preferential right or license (A) to issue standardized options overlying any instrument, index or other product, including options on securities based upon an index, or (B) to use any trademark, service market or similar right with respect to standardized options overlying any instrument, index or other product, including options on securities based upon an index.

(b) For purposes of this Rule, the term "exchange" shall mean a national securities exchange, registered as such with the Commission pursuant to Section 6 of the Securities Exchange Act of 1934, as amended.

(c) For purposes of this the term "standardized option: shall have the same meaning as that term is defined in Rule 9b-1 under the Securities Exchange Act of 1934, as amended, 17 C.F.R. 240.9b-1.

(d) For purposes of this Rule, the term "options class" shall have the same meaning as that term is defined in Rule 9b-1 under the Securities Exchange Act of 1934, as amended, 17 C.F.R. 240.9b-1.

 

http://www.sec.gov/rules/petitions/petn4-469.htm

Modified: 05/06/2003