John R.D. Corrie
J.P. Morgan Securities Inc.
60 Wall Street
New York NY
September 21, 2000
Mr. Jonathan W. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W. (Mail Stop 0609)
Washington, DC 20549-0609
Re: Rel. No. 34-43085, File No. S7-17-00
(Firm Quote and Trade-Through Disclosure Rules for Options)
Dear Mr. Katz:
J.P. Morgan & Co. Inc. ("J.P. Morgan") welcomes the opportunity to comment on the Commission's proposals to enhance the integrity of the nation's options markets.1 As a diversified financial services firm with a large institutional client base,2 one of our primary goals as options traders is to obtain best execution of large, hard-to-fill orders for sophisticated clients. With the modifications that we suggest below, we believe that the Commission's proposals to extend Rule 11Ac1-1 (the Firm Quote Rule) to listed options and to require trade-through disclosure will help us to achieve that goal.
I. Firm Quote Rule
J. P. Morgan strongly supports the proposed expansion of the Firm Quote Rule to include listed options. The lack of a uniform rule for the options markets has impeded firms' ability to execute customer orders in an efficient manner while they explore posted quotes to see whether they are firm for the entire order or only for an order of minimal size. These situations seriously compromise our ability to secure timely and orderly execution of customer orders. We hope that the proposed amendment to the Firm Quote Rule will enhance our ability to give our institutional clients better and faster execution.
One-Percent Exception. In fact, J.P. Morgan believes that the Firm Quote Rule should be even broader than proposed. There is no need for an exception to that rule for exchanges whose aggregate trading volume in a listed option is less than or equal to 1% of the total trading volume reported by the Options Price Reporting Authority (OPRA). The fact that a firm quote requirement may have a chilling effect on the liquidity of inactively-traded securities does not justify the burden that the exception would impose on brokers, who would be forced to keep track of which quotes were firm and which, because of the so-called "1 % exception," were not.
We are concerned that the 1% exception could pose significant compliance difficulties, since brokers would have to monitor the list of securities covered by the exception on a security-by-security basis for each of the five options exchanges. This burdensome monitoring process would be complicated by the fact that any such list of securities may vary substantially from one quarter to the next, as the 1% threshold would be recalculated on the basis of quarterly trading data. Unlike the equities markets, in which market shares for trading in particular securities are relatively stable, the increasingly competitive options markets are in a state of great flux regarding their respective market shares. On the whole, we believe customers would receive better and faster execution if their brokers could expect all published quotes to be firm for the specified size.
Quote Size. At this time, the Commission should not mandate that size be disseminated in the OPRA quote, because it would be too great a burden on the system. OPRA's capacity is strained even without the addition of size data, and the cost of expanding the system to include size data would be significant.3 This cost would be passed down to exchange members, brokers, and ultimately to customers on a per-trade basis. Furthermore, as the Commission recognized in its recent release approving the Options Market Joint Linkage Plan (Plan), "burdening the current OPRA system with modifications to add size could result in further deterioration of options quote integrity."4
J.P. Morgan also agrees with the Commission that each exchange should be allowed to establish its own firm quote size requirements. We believe, however, that any firm quote size set by the exchanges should be the same for both customer and broker-dealer proprietary orders. Distinguishing between customer and proprietary orders would not, as the Commission suggests, improve the quote for customer orders by insulating market makers from any potential exposure to large proprietary orders. The burden on the market maker of satisfying a quote is just as great for large customer orders as it is for large broker-dealer orders. In addition, broker-dealer proprietary orders are often placed in connection with bona fide hedging or other customer facilitation activities that may ultimately benefit public investors. Accordingly, we believe that one firm quote for all orders is preferable to a rule that would segment the market on the basis of order source.
Thirty-Second Response Requirement. J.P. Morgan agrees that there should be some time limit beyond which a broker is no longer required to wait for a market maker to respond before sending its order to another market maker. In most cases, given the current status of information technology, we expect that a 30-second response time probably would not unduly delay trades. The Commission should make an exception to the rule, however, for situations in which fast market conditions have been declared by one or more exchanges.5 In order to allow for optimal execution in the future, the Commission also should remain open to changing the response time as technology improves.
Relationship to the Limit Order Display Rule. J.P. Morgan also notes that, as drafted, the change to the definition of reported security in the Firm Quote Rule would have the effect of bringing options within Rule 11Acl-4 (the Limit Order Display Rule), which takes its definition of reported security from the Firm Quote Rule.6 Whatever the merits of this change, the Commission should clarify whether this is an intended result of the proposed amendment to the Firm Quote Rule; if so, we believe that the Administrative Procedure Act and the Regulatory Flexibility Act require that it be proposed separately for public comment with its own Initial Regulatory Flexibility Analysis.7 If the Commission does not presently intend to apply the Limit Order Display Rule to listed options, conforming amendments to the Limit Order Display Rule should be made to keep it unchanged.
II. Trade-Through Disclosure Rule
J.P. Morgan recognizes the policy objectives behind the proposed Trade-Through Disclosure Rule (Rule 11Ac1-7). We understand that this rule is intended, in particular, to benefit retail customers by deterring the occurrence of trade-throughs. While we believe that trade-throughs are a symptom of a deeper market structure problem, not a cause, we are mindful of the immediate need to address trade-throughs on the grounds of protecting public investors. Nevertheless, we believe that the proposed rule should be revised in several respects as follows.
Interaction with the Current Linkage Plan. As the Commission is well aware, the options exchanges have spent significant time and resources in developing a linkage plan that is built on the lessons of the equity markets. As recently approved by the Commission, the Plan provides that participants should generally avoid initiating trade-throughs and provides a remedy for violations if the injured party complains. Most trade-throughs should be deterred by this "forced trade" remedy. In approving the Intermarket Trading System (ITS) Plan, the Commission found that similar trade-through rules were adequate deterrents, and that after their adoption, the number of ITS transactions that the Commission identified as involving potential trade-throughs had dropped to less than one percent.8
For these reasons, J.P. Morgan believes that the Commission should modify the elements of a reasonable design in the proposed Trade-Through Disclosure Rule so that the newly approved Plan qualifies as reasonable without further amendment. Specifically, we are concerned that the additional factors proposed as elements of a reasonable plan to prevent trade-throughs (a ban on trade-throughs of unlinked exchanges, surveillance, disciplinary powers for the exchanges, policies and procedures, and recordkeeping) would add significant costs to the Plan, without adding significant additional deterrence. Thus, instead of requiring the exchanges to hold additional negotiations to amend the Plan, the Commission should approve the current Plan as one "reasonably designed to prevent trade-throughs" under the proposed rule. If, for some reason, the Commission believes that the Plan is insufficient, it should approach the exchange participants directly, rather than impose costs on market participants in an indirect effort to encourage the exchanges to develop a more efficient linkage.
Timing. If all of the options exchanges join the Plan, and the Plan in its current form is approved as reasonably designed to prevent trade-throughs (which we believe should be the case), the proposed Trade-Through Disclosure Rule would have little practical effect on our business. Even if one exchange were to remain outside the Plan, J.P. Morgan foresees only minimal significance of the proposed disclosure requirement, because customer orders would be routed to the non-linked exchange only where price improvement is available. Accordingly, we believe that if all or almost all of the options exchanges are reasonably expected to join the Plan in the near future, the Commission should delay the adoption of or the effective date of any trade-through disclosure requirement. It would not be cost-effective to require firms such as J.P. Morgan to re-design their confirmation systems to anticipate having to comply with such a rule, only to discover within a few months that the rule was obsolete because all options exchanges were members of an approved linkage.
Scope of the Proposed Exceptions. In general, J.P. Morgan supports the proposed exceptions to the definition of "trade-through" for stale quotes, for an exchange's failure to give accurate quotes or timely response, for trading rotations, and for inaccessible quotes due to systems malfunction. These exceptions should be amended, however, to include language providing brokers with reasonable discretion to interpret them broadly in light of their duty of best execution. For example, the Commission proposes an exception for "unusual market circumstances" that prevent an exchange from collecting or disseminating accurate quotes (other than system failure, which is proposed as a separate exception). A broker should have discretion to use the "unusual market circumstances" exception to refuse to route a trade to an exchange that has a history of disseminating "flickering" quotes, rather than being forced to disclose to the customer a trade-through of a phantom "better" price that, in all likelihood, never existed. This discretion is necessary to give the broker on-the-spot flexibility to make best execution decisions, instead of forcing the broker to incur the risk of subsequently providing an inferior price to a public customer against their better judgment.
Size Exception. J.P. Morgan strongly supports a size exception for large block orders. As the Commission suggests, these orders are often so large in relation to any particular quote that the quote bears little relationship to the ultimate average price per option. Disclosure that a broker-dealer traded through such a quote would be misleading, because the quote bears little relationship to the average price that the customer could get for the entire order. Customers placing large block orders typically conduct their own monitoring of execution quality, to which trade-through disclosure would add little or nothing. The National Association of Securities Dealers, Inc. (NASD) recognized the special considerations that apply to large block orders when it allowed for institutional customer and large volume exceptions to the "Manning" rules prohibiting trading ahead of customer limit orders.9 The Commission should add a similar exception to the Trade-Through Disclosure Rule.
Materiality Exception. J.P. Morgan believes that in a decimal trading environment, all orders (regardless of size) would benefit from an exception to the disclosure requirement for trade-throughs of amounts immaterial in relation to the spread. Such an exception ultimately makes disclosure more meaningful to public investors, who otherwise might be left with misleading impressions about "immaterial" trade-throughs that were made for other best execution reasons, such as speed and reliability. In addition, whether or not a materiality standard is used, we believe that any trade-through disclosure should include the size of the traded-through quote. Note, however, that we believe size disclosure would not be preferable to a materiality exception, because it would be more costly for market participants and ultimately for the customer.
The options markets are in the midst of a process of gradual structural reform. They should be allowed to continue to develop incrementally. This will allow the markets and the Commission to draw on the lessons of change in the equities markets while also considering factors unique to the options markets. With the amendments that we suggest, J.P. Morgan believes that the proposed rules will contribute to this process of gradual reform.
1 Rel. No. 34-43085, 65 Fed. Reg. 47918 (Aug. 4, 2000).
2 J.P. Morgan and its affiliates are also members of six options exchanges (the American Stock Exchange, Boston Stock Exchange , Chicago Board Options Exchange, International Stock Exchange, Pacific Exchange, and Philadelphia Stock Exchange).
3 See Rel. No. 34-42755 (May 4, 2000) (proposing an allocation formula for OPRA participants as a short-term solution to capacity shortages.).
4 Rel. No. 34-43086 (July 28, 2000), 65 Fed. Reg. 48023 (Aug. 4, 2000), at note 99.
5 The Commission has approved a number of exchange rules that provide for special handling of orders under "fast market" conditions in both the options and the equities markets. See Rel. No. 34-40006 (May 19, 1998) (approving a Philadelphia Stock Exchange plan for automated routing and execution of equity orders that includes exception to price improvement requirement for fast market conditions); Rel. No. 34-39635 (Feb. 9, 1998) (approving a Pacific Exchange rule that suspends operation of the automatic execution system for options when two Options Floor Officials declare fast market conditions); Rel. No. 34-38972 (June 30, 1997) (approving a Philadelphia Stock Exchange Automated Options Market order entry and routing system, which contains an exception for extraordinary circumstances, including fast market conditions); Chicago Board Options Exchange Rule 8.51(a)(4) (similar exception).
6 Rule 11Ac1-4(a)(20).
7 5 U.S.C. §§ 553, 603.
8 See Rel. No. 34-19456 (Jan. 27, 1983).
9 NASD IM-2110-2.