Philadelphia Stock Exchange, Inc.
February 12, 2003
Mr. Jonathan G. Katz
Re: Proposal by the Boston Stock Exchange, Inc. to Establish the Boston Options Exchange; SR-BSE-2002-15
Dear Mr. Katz:
The Philadelphia Stock Exchange, Inc. ("Phlx") welcomes the opportunity to offer our comments to the Securities and Exchange Commission ("Commission") on the above-referenced filing, in which the Boston Stock Exchange, Inc. ("BSE") proposes to establish a new trading facility for the trading of standardized options - the Boston Options Exchange ("BOX").1 As discussed below, the Phlx does not believe that the BOX proposal complies with the requirements for approval of a self-regulatory organization ("SRO") rule filing, as set forth in the Securities Exchange Act of 1934, as amended ("Exchange Act").2
The Phlx believes that the BSE filing is incomplete and does not contain sufficient information to permit meaningful public comment or to permit the Commission to make a finding that the proposal is consistent with the Exchange Act.3 In addition, the proposal, as published, does not satisfy the standards set forth in Sections 6(b)(5),4 6(b)(8),5 and 11A6 of the Exchange Act, because it imposes an inappropriate burden on competition, permits unfair discrimination between brokers and dealers, and is at odds with the fundamental goals of a National Market System. Moreover, the Phlx would find it incomprehensible for the Commission to approve at this time the BOX proposal - a trading system specifically designed to promote internalization of customer orders - in light of Chairman Pitt's strong criticisms of the practice of internalization in the listed options markets.7
Finally, the Phlx believes that the proposed operation of the BOX system is inconsistent with the Plan for the Purpose of Creating and Operating an Intermarket Options Linkage (the "Linkage Plan").
The BSE represents that it intends to file under separate cover a proposed rule change regarding the delegation of authority from the BSE to Boston Options Exchange Regulation, LLC ("BOXR") for regulatory functions related to the facility ("Delegation Plan"), and a proposed rule change regarding the relationship between the BSE, BOXR, and various "BOX entities." However, without reviewing these filings, neither the Commission nor commenters can hope to evaluate whether the BOX as an options trading facility of the BSE is consistent with the Exchange Act. In particular, without the opportunity to review these filings before approving the BOX facility, the Commission would be unable to ensure that the proposal is consistent with Section 6(b)(1) of the Exchange Act,8 which requires a national securities exchange to enforce compliance by its members and persons associated with its members with the provisions of the Exchange Act, the rules and regulations thereunder, and the rules of the exchange. The Exchange requests that the Commission not take action on the BOX proposal until such time as the Delegation Plan and related rule proposals are filed with the Commission, published in the Federal Register, and the appropriate period for public comment has expired.
The proposed rules also are incomplete concerning membership and participation in the BOX. The Release states that membership is contingent on the prospective member satisfying the conditions of the Option Participant Agreement (the "Agreement"). However, there is no discussion in the Release of the substantive terms of the Agreement, nor is the Agreement included as an exhibit or attachment to the Release. It is, therefore, impossible for commenters to know the additional conditions with which a member/participant must comply. The Phlx believes that commenters should be given the opportunity to address whether any conditions on membership/participation are consistent with the Exchange Act, particularly Section 6(b)(2),9 which requires that the rules of an exchange, subject to limited exceptions in Section 6(c),10 provide that any registered broker-dealer or natural person associated with a registered broker-dealer may become a member.
For all of the above reasons, the Phlx believes the filing is deficient and should not be acted upon until the deficiencies have been cured. Although the Phlx believes that the proposal is incomplete, there are a number of issues raised by this filing that the Phlx wishes to comment on at this time.
· The trading platform proposed by BOX takes to a new extreme the practice of internalization - one of the practices so heavily criticized by Chairman Pitt.
Chairman Pitt states in his January 24th Letter that economic inducements to order flow providers and internalization by options exchange members "create serious conflicts of interest that can compromise a broker's fiduciary obligation to achieve best execution of its customers' orders."11 For various reasons described in the Phlx's response to Chairman Pitt's letter,12 the Phlx is not yet convinced that the potential hazards of internalization, including the potential conflict of interest concerns, merit banning internalization and participation guarantees altogether. Nonetheless, the Phlx recognizes that, taken to an extreme, internalization practices could be highly detrimental to the securities markets, and, thus, the Phlx would endorse further study of the matter by the Commission and the Intermarket Surveillance Group. In the interim, in light of Chairman Pitt's indictment of broker-dealer internalization practices in the listed options market, the Commission cannot, consistent with Chairman Pitt's views, approve the BOX proposal because it creates a market structure that permits - and indeed encourages - internalization more so than any other exchange. The Phlx would find approval of the BOX particularly inequitable in light of the fact that, for competitive reasons, the Phlx has filed a proposed rule change (SR-Phlx-2002-17) essentially copying the rules of other options exchanges with respect to percentage guarantees for crossing and facilitation transactions and the staff of the Division of Market Regulation has delayed implementation of this rule (even though its effect is merely to put the Phlx on a level playing field with other exchanges).
The BOX proposal facilitates internalization because the proposed BOX rules permit an OFP to enter into the system for execution a customer order accompanied by its own principal contra-side "Primary Improvement Order," without offering a fair and reasonable opportunity for other market participants to interact with that order, so long as its own order is for the same size as the customer order and is priced at least $.01 greater than the then-National Best Bid/Offer ("NBBO"). As explained below, the 3 second "Price Improvement Period" or "PIP" simply does not provide market participants with a sufficient length of time in which to assess their positions, risk, and market conditions and respond to the OFP's order. In fact, the 3 second PIP is less than a third of the exposure time insisted upon by the Commission when the International Securities Exchange LLC ("ISE") - also an electronic exchange - sought to reduce the exposure time for internalized orders brought to the ISE for execution.13 Furthermore, this "penny increment" PIP process appears to not provide a true value-added benefit to the customer, rather a process to solely internalize orders.
· The proposed three-second Price Improvement Period ("PIP") is a specious "auction" model designed solely to allow OFPs to capture and internalize 100% of customer orders.
Among the goals of a National Market System, which are contained in Section 11A of the Exchange Act, is to assure "fair competition among brokers and dealers."14 The Exchange believes that the proposed three-second "PIP" not only does not come close to meeting this goal, but in fact is specifically designed to circumvent legitimate competition among brokers and dealers.
The BSE represents that, in order to preclude unfair internalization, BOX rules prevent an OFP from entering simultaneous customer and proprietary orders before there is an opportunity for the customer order to interact with other trading interest on the BOX. BSE claims that the preventive cure to preclude 100% internalization is a mere three-second PIP, during which BOX market makers may "compete" for the customer execution in one-cent increments. The Exchange believes that a three-second period does not provide a sufficient opportunity for BOX market makers to compete within the PIP, and that the PIP is not a legitimate "auction." Clearly, the only way that a BOX Market Maker may participate in a PIP is by employing sophisticated automated systems that analyze and respond to every order through preprogrammed trading algorithms. In this regard, the BOX's market structure discriminates against those broker-dealer participants that do not have the resources to invest in expensive computer technology and, thus, is inconsistent with Section 11A's direction to the Commission to assure fair competition among brokers and dealers.
In addition, although an OFP's customer is assured a price $.01 greater than the prevailing NBBO, further opportunities for price improvement, as a practical matter, are virtually non-existent. One of the most important functions of a specialist or market maker on an exchange is to engage in price improvement, whereby a customer order is executed at a price more advantageous to the customer. Indeed, this concept is one of the primary underpinnings of best execution in an auction market. The PIP, on the other hand, is actually a race to the market based on which participant has the fastest, most advanced computer system.
Finally, we note that as the volume of internalized orders increases as a result of the BOX market structure, market makers may be forced to increase their spreads to make up for the loss in volume. This ultimately may result in worse prices for all customers because the prices used for the PIP are based on the NBBO, which is nothing more than the collective spreads of all market makers in a particular option. As noted in Chairman Pitt's January 24th Letter, internalization in the options markets may contribute to an environment where quote competition may not be rewarded, thereby discouraging the display of aggressively priced quotes.15 If further study by the Commission and/or the ISG were to confirm this fact, such lack of quote competition would be inconsistent with one of the primary goals of the National Market System - to assure the practicability of brokers executing investors' orders in the best market.16
· The quotation size requirements set forth in the proposed BOX rules are vague and could subject BOX Market Makers to considerable risk.
Section 6(a) of Chapter VI of the proposed rules sets forth a minimum quotation size requirement of 10 contracts for BOX Market Makers for "every Market Maker bid or offer." It is unclear from the proposed rules, however, whether the "10-up" requirement applies to all series in an option class or to just the option class. If the intent is to require "10-up" quotations in every series, BOX Market Makers could be required to execute at least 10 contracts in multiple series in an option class, which could occur simultaneously. In such a circumstance, especially in option classes in which there are numerous series listed (in some options classes there can be up to 300 series listed), the BOX Market Maker would be required to execute an exponentially greater number of contracts in a given option, and would be required to revise quotes in each series within fractions of a second of the execution to avoid another execution at the same price.
The BSE does not address how competition is furthered by exposing Market Makers to this level of risk or whether there is some type of mechanism embedded in the BOX trading system that protects BOX Market Makers from virtually unlimited market risk in connection with the "10-up" requirement. If there is some sort of technological safeguard in the system, its existence certainly is not clear from the Release. On the other hand, the intent may be for the "10-up" requirement to operate by class, in which case the liquidity available on the BOX would be significantly less than that implied by the Release. Moreover, if this is the intent of the filing, we note that there is no indication as to how the 10-up requirement for each market maker would be allocated to various series within each options class. In either case, however, market participants should not be required to guess at how the 10-up requirement applies. The BOX rules and the Release need to be amended to make these points clear.
An additional concern arises regarding the firm quotation size requirement in the proposed BOX "Thirty Second Rule" (Chapter VI, Section 6(c)iii.), which requires BOX Market Makers to fill the entire order or their own published quotation size (and revise the quote) within 30 seconds of receipt of an order greater than their size. The Quote Rule17 under the Act applies to exchanges that must either collect and disseminate, or periodically publish, their quotation size. This proposed rule should apply to the BOX published quotation size, not to the size of individual Market Makers.
· It is unclear as to whether BOX is compatible with the Linkage Plan.
In the event that BOX files rule changes and makes representations sufficient to allow it to become an options trading facility, the BOX structure appears to be inconsistent with the Linkage Plan in its current form. Specifically, while BOX proposes an anonymous order entry process where price-time priority determines the sequence in which orders are executed, participants in the Linkage Plan are required to submit Principal Acting as Agent ("P/A") Orders, orders for the principal account of a specialist (or equivalent entity on another Participant Exchange that is authorized to represent Public Customer orders), reflecting the terms of a related unexecuted Public Customer order for which the specialist is acting as agent; and Principal ("P") Orders, for the principal account of an Eligible Market Maker. It is thus impossible for a market maker to send a P/A or P order to BOX anonymously.
There is no specialist to forward P or P/A orders from the BOX to other exchanges for execution, and there appears to be no person responsible or accountable for Trade-Throughs (a transaction in an options series at a price that is inferior to the National Best Bid/Offer) or Satisfaction Orders (defined as an order sent through the Linkage to notify a member of another Participant Exchange of a Trade-Through and to seek satisfaction of the liability arising from that Trade-Through) received from other exchanges or sent to other exchanges.
There is no description in the Release as to how BOX intends to handle this anomaly, and until such a proposal is made public for comment, and the issue is sufficiently dealt with by the Commission, the Exchange requests that the proposal not be considered for approval.
For the foregoing reasons, the Phlx believes that the BSE filing: (1) does not contain sufficient information to permit meaningful public comment or to permit the Commission to make a finding that the proposal is consistent with the Exchange Act, and (2) does not satisfy the standards set forth in Sections 6(b)(5),18 6(b)(8),19 and 11A20 of the Exchange Act, because it imposes an inappropriate burden on competition, permits unfair discrimination between brokers and dealers, and is at odds with the fundamental goals of a National Market System.
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We appreciate the Commission's consideration of our comments. If the Commission or its Staff should have any questions regarding the matters discussed above, please contact Lanny A. Schwartz, Executive Vice President and General Counsel at (215) 496-5406.
cc: Harvey L. Pitt, Chairman