June 12, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Proposed Amendments to National Market System Plan Release No. 34-42755; File No. 4-434
Dear Mr. Katz:
The Philadelphia Stock Exchange, Inc. ("Phlx" or "Exchange") appreciates the opportunity to comment on the proposed amendments (the "Proposal") to the Options Price Reporting Authority ("OPRA") Plan for temporary allocation of OPRA's message handling capacity during the current period of extreme capacity constraint.
The Phlx agrees with the Securities and Exchange Commission ("SEC" or "Commission") that the industry must find a new, and better, way to allocate and increase OPRA systems capacity, both in the current extraordinary environment and in the long-term, and to ensure complete transparency of quote information throughout the options industry.1 In this regard, the Phlx wishes to emphasize that OPRA capacity must be increased and that any allocation system where the capacity available to one exchange is dependent upon the capacity received by another is harmful to the National Market System and restrains competition. Moreover, the capacity constraints of information vendors to receive OPRA data contribute to the problem of ensuring transparency and also must be addressed. At present, OPRA itself is capable of transmitting 8,000 messages per second, but cannot do so because many vendors cannot receive more than about 3,500 messages per second.
The Phlx believes that OPRA's capacity problems will not be resolved fully until the OPRA system is reformed. Specifically, the Phlx would support a market-based system in which each exchange receives, and pays for, the OPRA capacity that it needs.2 Then, each exchange can manage its resources as it sees fit and shortages should become a thing of the past. The Phlx also urges the Commission not to limit its efforts to the short term and to begin now the process of finding a new way to address OPRA capacity. Furthermore, the Phlx respectfully suggests that, rather than forcing options exchanges to limit their quoting volume through an allocation system, the Commission could substantially eliminate the current message capacity crisis by asserting jurisdiction over information vendors pursuant to Section 11A(c)(1)(B) of the Securities Exchange Act of 1934 (the "Exchange Act") and requiring the vendors to immediately increase their capacity to receive OPRA messages. Recognizing that a short-term emergency measure is required, however, the Phlx, unhappily, agrees with the Commission that an options data capacity allocation formula is needed to ensure that scarce OPRA systems capacity is allocated among the options exchanges fairly and on a basis that encourages competition.3
With regard to the temporary allocation methodologies that are the subject of the proposal, the Phlx opposes adoption of either Alternative A or Alternative B because they create disincentives to list new options and do not provide an incentive to quote economically. Moreover, the Commission's proposals would serve to perpetuate current market share and make it all but impossible for smaller markets to be effective challengers for market share. Both alternatives are, therefore, inconsistent with the goals of the National Market System as expressed in Section 11A of the Exchange Act. Instead, we propose a temporary allocation scheme (the "Phlx Short-Term Alternative") that builds on the best features of Alternatives A and B and that will enhance transparency, competition, efficiency and fairness. .
Allocating OPRA systems capacity should not, and need not, come at the expense of competition among exchanges. Certainly, the capacity allocation mechanism should not create a disincentive for exchanges to list new options or to list options traded on other exchanges. In addition, an allocation formula should create an incentive to use scarce capacity prudently.
The Phlx supports the basic tenets of the Commission's proposal, that the capacity allocation scheme encourage efficient quoting and discourage the listing of options for which there is little trading interest. Therefore, the Phlx proposes below an alternative temporary allocation formula, which, in part, combines the best features of Alternatives A and B. The Phlx short-term alternative furthers the following goals:
The Commission's Proposed Temporary Allocation Models
Alternative A, as proposed by the Commission, would temporarily allocate capacity based on the average quotation volume of options classes listed on each exchange that have sufficient trading volume to meet a minimum threshold -- so-called "Included Classes." Specifically, for each multiply-traded options class, an exchange for which that class is an Included Class would be allocated capacity based on the average quoting frequency (during the first half-hour of the trading day after the opening rotation) across all exchanges for which that class is an Included Class. For options classes listed on only one exchange, an exchange would be allocated capacity based on the average quote traffic generated during the first half-hour of trading after the opening rotation, if the Exchange's trading volume was sufficient for that class to be an Included Class. An options class is deemed an "Included Class" for an exchange if an average of 15 trades per day4 take place on that exchange if the class is multiply-listed, or 30
trades per day if the class is exclusively-listed. An options exchange receives capacity credit only for those options classes in which it exceeds these minimum levels of trading activity.5
The Phlx supports the tenets of Alternative A that exchanges should quote efficiently and that capacity should not be allocated for any options classes that customers have no interest in trading. Nonetheless, the Phlx cannot support Alternative A because it would reduce competition by discouraging exchanges from listing options already traded on one or more other exchanges. Alternative A does create a disincentive to quote "excessively" in multiply-traded options.6 But, Alternative A provides no allocation credit to an individual exchange for options classes that are below a certain volume threshold on that exchange, even though the option would be included in other exchanges allocations. Thus, an exchange may decide not to list an option solely out of concern that the exchange will not attract the requisite volume to secure a Capacity Credit in that particular options class. An exchange could have legitimate concerns that, while it believes that an option has the potential to achieve substantial trading volume, initial volumes will be low (but quote volume could be high -- particularly if it is a volatile issue) and that the exchange will not meet the minimum volume requirements. The effect of Alternative A would likely be to discourage an exchange from listing an option, especially one that is already traded on one or more exchanges. Alternative A's proposed trading volume minimum requirements would stifle competition among exchange markets -- a result patently inconsistent with the goals of the national market system as expressed in Section 11A of the Exchange Act.7
Under Alternative B, capacity would be allocated equally among all options exchanges with adjustments based on an exchange's deviation from the overall market's ratio of quotes to contract volume, subject to a minimum allocation to each exchange of 15 percent of OPRA's total systems capacity. The Commission states that its goal under Alternative B is to encourage "efficient" quoting (and, thus, economical use of scarce capacity) by awarding an exchange a larger allocation if it has a lower ratio of quotes to contracts. Alternative B is deeply flawed because it is based on an inappropriate measure of quoting efficiency.
The use of equal shares as a baseline in Alternative B reflects the fundamental fact that a specialist must issue quotes to compete for trading volume in an option series. The Phlx supports the use of equal shares of capacity. However, Alternative B is problematic because it adjusts the equal shares based on an exchange's deviation from the average ratio of quotes-to-contracts. That is not reasonable because the frequency or number of quotes for an option series is directly related to conditions in the market for the underlying equity or index components and is generally not related to trading volume for the option series. The emphasis on the ratio of quotes to volume would not create any incentive to use scarce resources efficiently, but would discourage new listings because an exchange would fear that, regardless of its potential, a new listing could initially trade with low volume, reducing the exchange's capacity allocation. Thus, relying on the ratio of quotes to volume has the effect of penalizing an exchange for attempting a new listing or, even worse, penalizing an exchange for attempting to list an existing option with relatively high trading volume and high quoting volume.
Another flaw with using a quote-to-volume or quote-to-trade ratio as a measure for capacity allocation is that it could give two exchanges that issue the same number of quotes for the same options different capacity allocations. Since the frequency of quotes for an option is related primarily to the conditions in the market for the underlying security, two exchanges that list a similar number of series should have nearly identical quoting volume. Nonetheless, the exchange with the lower volume will have a higher quote-to-contract ratio because of its lower volume, not because it quotes less efficiently. Accordingly, as proposed, the allocation formula in Alternative B would actually take capacity away from an exchange that is using its quoting allocation more efficiently than another exchange if the more efficient exchange has lower trading volume. As a result, Alternative B fails to encourage efficient use of capacity and fails to achieve one of the most important goals of any allocation scheme. Moreover, it would tend to reward markets for achieving trading volumes that were not necessarily related to aggressive or efficient quoting, but were attributable to such factors as payment for order flow, internalization and other arrangements between market participants and order flow providers.
Alternative B would restrain competition by inhibiting the ability of lower volume exchanges and new entrants to compete with higher volume exchanges. Such a system would be very harmful to the markets because it would enshrine existing market positions by denying other competitors the means to expand their market share. The flaws in Alternative B are illustrated by the result that it would allocate disproportionate capacity to an exchange with very few option products, but with high volume or large trading activity in those products. However, there is no basis for the inference that such an exchange uses OPRA capacity more efficiently than other exchanges.
Alternative B's apparent premise that a rapidly updated and comprehensive quotation stream is harmful or inefficient is incorrect. Quotations provide important information to the marketplace, and, in a properly configured market structure, should be a principal driver of competition. The Phlx believes that the information, depth and transparency of markets that are fostered by the quotation streams generated by all exchanges are equally valuable to investors regardless of the amount of trades that are executed on a particular market.8
The problems of Alternative B would be exacerbated in a marketplace with linkage among exchanges that does not require price-time priority (i.e., a system in which a market that receives a marketable order can retain that order, rather than send it to an another market that is displaying a better price, merely by "matching" the better bid or offer) because both systems would perpetuate incumbent market shares. Linkage without price-time priority rewards payment for order flow, internalization and other arrangements between markets or exchange specialists and order flow providers whereby volume is not necessarily the result of aggressive quoting but factors unrelated to the quality of the exchange's quotations.9 Alternative B does so as well because of the additional capacity allocation that increased order flow can earn. The combination could well be fatal to smaller competitors and deter new entrants. That would not, of course, further the goals of the National Market System.10
Phlx Short-Term Alternative
The Phlx's capacity allocation model is based on the premise that the goal of any temporary allocation scheme should be equal shares among the exchanges. Recognizing that equal allocation is not achievable overnight, however, the Phlx's model phases equal shares in over time. Moreover, recognizing that exclusively-listed, multiply-listed, and index options each use different amounts of capacity, the Phlx allocation model treats these groups differently.11
The Phlx's capacity allocation model would begin by allocating a fixed percentage of total OPRA systems capacity equally among the five options exchanges, and then allocating the remaining OPRA capacity ("Remaining Capacity") in accordance with the parameters discussed below. The fixed percentage of capacity allocated equally among exchanges would increase gradually each calendar quarter. Using the Phlx methodology, the first quarterly allocation would begin by allocating 10% of the total OPRA systems capacity equally among the five exchanges (i.e., 2% per exchange) and the Remaining Capacity (90% in the case of the first quarterly allocation) would be allocated as set forth below. At the end of each calendar quarter, the equal allocation would be increased by 10% of total OPRA systems capacity, until 100% of total OPRA systems capacity is allocated equally among the participants. The allocation of the Remaining Capacity among exchanges would also be redetermined on a quarterly basis as described below based upon quoting volumes for the preceding "benchmark" calendar quarter (i.e., in order to permit the adjustment calculations to be made, quarterly allocations could be made based upon performance during a calendar quarter that ended 30 or 60 days prior to the current quarter).
Allocation of Remaining Capacity
The allocation percentage for all OPRA participants would be determined on a quarterly basis. An exchange's total capacity allocation for a given calendar quarter will consist of the applicable equal allocation for the quarter (10% for the first quarter) and the allocation percentage for the Remaining Capacity. The allocation percentage for the Remaining Capacity for each exchange would be determined by summing all of an exchange's Capacity Credits with respect to the benchmark period and dividing by the total of all Capacity Credits for all exchanges.
As discussed above, the allocation scheme we propose should only be a short term emergency solution because, ultimately the markets will best serve investors if each exchange's capacity allocation is not dependent on another exchange's use of OPRA capacity.12 The Phlx proposal would require exchanges to use capacity efficiently by equating (in the case of equity options) capacity allocations with industry averages for each exchange. It addition, it would neither favor or disfavor new entrants because a new entrant would receive (in the case of equity options) an allocation equal to the industry average for each series that it lists that is already traded and an allocation for each series that reaches the volume thresholds above.
As a final matter, the Phlx emphasizes that it may be necessary for the Commission to exercise its authority to regulate securities information vendors. If the Commission does not do so, it is possible that, even if the OPRA plan successfully increases capacity, the information vendors will be unable to transmit complete options market quote information. Section 11A(c)(1)(B) of the Exchange Act provides the Commission with broad authority to adopt rules to assure the prompt, accurate, reliable and fair collection, processing, distribution, and publication of transaction and quotation information. Indeed, it was under this broad grant of authority that the Commission adopted the Rule 11Ac1-2, commonly referred to as the Vendor Display Rule.13
We appreciate this opportunity to express our views. If the Commission staff have any questions or comments regarding the points made in this comment letter, or need clarification of any of the positions discussed herein, please contact Lanny A. Schwartz, Executive Vice President and General Counsel, at (215) 496-5406.
Meyer S. Frucher
cc: The Honorable Arthur Levitt, Chairman
The Honorable Norman S. Johnson, Commissioner
The Honorable Issac C. Hunt, Commissioner
The Honorable Paul R. Carey, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Deborah L. Flynn, Senior Special Counsel, Division of Market Regulation
Terri Evans, Special Counsel, Division of Market Regulation
Kelly Riley, Attorney, Division of Market Regulation
John Roeser, Attorney, Division of Market Regulation
Heather Traeger, Attorney, Division of Market Regulation
|1||The Exchange notes that it has cooperated fully with the Commission and has acted in the best interests of the market as a whole by making a good faith effort to reduce options quote traffic. In this regard, the Phlx has delisted 168 equity options through May of 2000 and has only listed 37 new equity options, for a net decrease of 131 equity options. All of the other operating options markets have a net increase in listings through May of 2000 (in some cases a substantial increase).|
|2||Of course, all OPRA costs would have to be internalized for such a system to encourage competition.|
|3||The current system is, of course, not acceptable because it both reduces transparency and limits the ability of the exchanges to offer new products (the Phlx has, in fact, felt constrained in this regard and has generally restrained from listing new options).|
|4||Although the Phlx does not support the per exchange minimum trading volume requirement in Alternative A, using a minimum threshold of 15 contracts per day is a more appropriate measure than 15 trades per day. The industry has long held the view that the more accurate measure of trading volume is the number of contracts that change hands as opposed to the number of trades.|
|5||The Exchange believes that the nine month period during which all options classes listed on a new exchange are deemed "Included Classes" is arbitrary and excessive. New entrants will receive adequate capacity if the Commission adopts the methodology we propose.|
|6||Alternative A provides no disincentive to quote "excessively" in exclusively-traded options. Because of the lower quote traffic per exchange generated by each singly-listed option, that is probably the right result.|
|7||Section 11A(a)(1)(C)(ii) provides that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets (emphasis added). In addition, Section 23(a)(2) of the Exchange Act requires that the Commission, when promulgating rules under the Exchange Act, to consider the proposed rule's impact on competition.|
|8||See Letter from Meyer S. Frucher, Chairman and Chief Executive Officer, Phlx, to Jonathan G. Katz, Secretary, SEC, dated April 6, 2000 (Phlx comment letter to SEC Release No. 34-42208 regarding the regulation of market information fees and revenues.)|
|9||See Letter from Meyer S. Frucher, Chairman and Chief Executive Officer, Phlx, to Jonathan G. Katz, Secretary, SEC, dated May 18, 2000 (Phlx comment letter to SEC Release No. 34-42450 regarding market fragmentation).|
|10||See supra note 7. Another important criticism of the Commission's proposed allocation methodologies is that the Commission does not specify a trigger point for ceasing to allocate capacity. This is important because it could lead to a situation where excess capacity could be allocated to one exchange, but insufficient capacity allocated to others, even at a time when capacity would be adequate to meet all exchange's current and reasonably anticipated needs.|
|11||We understand that on average a singly-listed option generates approximately 25,000 quotes per month, a multiply-listed option generates on average about 350,000 quotes per month and an index option generates on average over 850,000 quotes per month.|
|12||The Phlx supports the Commission's view that if an options exchange generates and transmits to OPRA message traffic in excess of its allocation, the Exchange should notify the public that it has exceeded its established allocation and its disseminated quotes are likely to be unreliable.|
|13||See Exchange Act Release No. 16590 (February 19, 1980) (Adopting Release for Rule 11Ac1-2). See Also Exchange Act Release No. 42208 (December 9, 1999) (Concept Release on the Regulation of Market Information and Fees and Revenues).|