Susquehanna International Group, LLP
Susquehanna International Group, LLP ("SIG") appreciates the opportunity to provide comments on the above-captioned amendment ("the amendment") to the proposed electronic options trading facility of the Boston Stock Exchange ("BSE") called the Boston Options Exchange ("BOX"). The amendment proposes to change certain aspects to its Price Improvement Process ("PIP") and trading rules surrounding that process.
In a comment letter of February 12, 2003 responding to the original BOX proposal (SR-BSE-2002-13), SIG asserted that the BOX seeks to isolate its trading activities from other market participants by blocking their ability to view and access the PIP quotes. Our concern was that it would be inherently unfair to the options market for the Commission to permit participants to trade in non-disseminated penny increments on a single exchange, as BOX proposes for its Price Improvement Process ("PIP"). The PIP allows BOX market participants to both trade and quote in pennies without exposing that trading interest to the market or making it eligible to be accessed through linkage. The trading interest in question cannot be viewed except by a very few BOX participants. The PIP, thus, represents the complete antithesis of the transparent and freely accessible market that the Commission espouses.
If the SEC approves the PIP, it should require that all exchanges have the ability to quote and trade in pennies,1 or at a minimum, that PIP penny quotes be included in the NBBO and exposed to the broader market. If, instead, the SEC determines that it is consistent with the Exchange Act's national market provisions to allow market participants on an exchange to internalize at prices not available to the national market in general, then it should resist allowing one market to do so until the other markets have a fair opportunity to put in place their own similar systems. While allowing markets to trade in this fashion would be detrimental to the options market, and is an approach that we do not advocate, it would at least allow all exchanges a fair opportunity to compete on the same basis. Otherwise, the effort to create a national market system through options linkage will be completely muted. If the Commission were to take this step, however, it should only do so after a thorough study of the broader market structure issues involved. We understand that the Commission staff has been working on a concept release related to some of these issues in the options markets. Before approving the PIP, the Commission should include the PIP in the concept release so that it can solicit and consider the comments received thereon.
SIG remains committed to intermarket linkage and the dissemination of the National Best Bid or Offer (the "NBBO"). Intermarket linkage and dissemination of the NBBO promotes competition between market participants on different exchanges and provides investors the transparency they need to make informed investment decisions and to evaluate the quality of services provided by their securities professionals. As currently conceived, PIP quotes will be hidden and excluded from the NBBO and only market participants on BOX will have the opportunity to interact with PIP quotes.2 If the SEC condones the omission of PIP quotes from the NBBO, it will ensure that no price improvement beyond a penny occurs either on BOX or when the other exchanges undoubtedly adopt their own competing hidden penny quote, PIP-like procedures. In fact, the more likely scenario is that "silos" of trading, or fragmentation, will occur whereby each exchange will have its own hidden trading markets.
The PIP Violates Rule 11Ac1-1
The PIP violates the SEC's Quote Dissemination Rule (" Rule 11Ac1-1" or "the Quote Rule"). The Quote Rule requires each exchange to maintain procedures and mechanisms to collect, process and disseminate the best bids and offers communicated on each respective exchange. Despite this requirement, the amendments contemplate that BOX will not disseminate any of the bids and offers it collects and processes during the PIP. Although Rule 11Ac1-1(b)(i)(A) does contain an exception from the Quote Rule for immediate or cancel orders (i.e., the Floor Exemption), the PIP bids and offers are not entitled to this exemption as they are not immediate or cancel orders. To the contrary, such orders are required to be maintained for the entirety of the PIP.
Moreover, the Floor Exemption was not designed to allow the internalization of small lot orders as is contemplated by the PIP and should, thus, not be extended to the PIP. The Floor Exemption was deemed necessary so that members can work not-held orders in the crowd and thereby provide a mechanism for them to find liquidity in block sizes on exchange floors in a manner that keeps market impact at a minimum. Although certain off-floor exchange systems (such as the Phlx's VWAP system) have been adopted, they in each case successfully make the argument that their systems are for the purpose of facilitating block sized orders. While these systems are viewed as attempts to replicate the Floor Exemption in an upstairs auction manner, BOX gives no explanation as to why it should be approved for an exemption.
The PIP is the first attempt at deploying the Floor Exemption in a manner totally inconsistent with the original premise for the exemption. That is, the execution of small-lot orders in an off-floor electronic execution system. The fact that it attempts to do so through the deployment of prices unseen and unavailable to most market participants makes the proposal the antithesis of Rule 11Ac1-1 in general and the Floor Exemption specifically. The Floor Exemption should not be used as a mechanism to permit the internalization of small-lot orders.
The BSE makes several changes to the PIP in an attempt to address internalization concerns. For the most part, these changes are merely window-dressing that will not affect the ability to internalize on the PIP to any significant degree. First, the BSE proposes that there be three market makers quoting for a PIP to begin. The market makers do not have to be quoting at or near the NBBO for this standard to be met, so it is highly likely that there will be at last three market makers for each significant option issue and that this requirement will not constrain the ability to internalize on the PIP. Second, the BSE proposes to allow customer participation orders in the PIP. These orders, however, have to be predesignated with the improved price and be quoted at the NBBO at the time of the PIP. Moreover, the customer's broker must separately enter the order within the three second life of the PIP. These conditions make it highly unlikely that any customer orders will participate in the PIP. Finally, the OFP in a PIP can not be the market maker prime, thus limiting its participation to 40 percent if its quote is matched. This change will only reduce the minimum amount of profit an OFP can make on an internalized trade, but will not lessen the incentive to internalize in the first place.
The BSE proposes to make one change to the PIP that will affect the internalization potential of the PIP, but in the wrong direction. Specifically, the BSE proposes to allow market makers to receive directed orders and enter these orders into the PIP. This will enable firms without customer order flow to internalize to pay for directed order flow that they can trade against in the PIP. Thus, the one material change to the PIP proposed by the BSE will actually increase the use of the PIP for internalization.
A BOX market maker is only being asked to make markets in 80 percent of the series and in 90 percent of classes. This provides BOX market makers with a significant advantage over competitor market makers on floor exchanges. To a large extent, market makers on trading floors assume great risk in making markets in far term and LEAP series where pricing is more difficult. Yet these are often important option series for investors with long term hedging needs. Market makers are provided with certain financing and execution incentives to compensate them for the risks of having to make two-sided markets in options that present risks that the market maker would not otherwise assume. Yet, on the BOX, a market maker can ignore the difficult series and still meet its quoting obligation because very far term and LEAP series will not account for 20 percent of the series of options classes. No trader should be permitted market maker status for only trading the less risky options series.
The amendments fail to address the major deficiencies with the BOX proposal as outlined in our comment letter of February 12, 2003. Although we agree that innovation should be encouraged, the lynchpin of BOX - the PIP - is not based on innovation, but on allowing the BOX to play by different rules than every other options exchange. No market participant other than BOX members can trade in penny increments and then only if certain favored market participants (i.e., OFPs) initiate a PIP. BOX then contemplates that this trading be conducted in private so that market participants on other exchanges cannot compete or even know that this secret auction is occurring. The SEC should not grant BOX preferential treatment. All exchanges should be permitted to play by the same rules. Either all market participants should be permitted to trade in pennies without the obligation to integrate their penny quotes into the NBBO, or no market participants should be permitted to do so.
For the foregoing reasons, we respectfully request that the Commission disapprove the BOX amendments.
cc: William Donaldson, Chairman