December 9, 2002
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Pacific Exchange, Inc. Proposed New Trading Platform for Options, PCX Plus, Release No. 34-46803 (November 8 , 2002), 67 FR 69580 (November 18, 2002) (SR-PCX-2002-36) (the "Release")
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 Pacific Exchange, Inc. ("PCX") proposes to establish a new trading platform for options known as "PCX Plus." As described below, the Phlx does not believe that the PCX Plus 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").1
The Phlx believes that the proposal, as currently structured, imposes a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act by creating a market structure that makes it virtually impossible for PCX Market Makers that are not Lead Market Makers ("LMMs") to compete on the basis of price. Accordingly, the proposal is inconsistent with Section 6(b)(8) of the Exchange Act.2 In addition, the Phlx believes that, by systematically favoring LMMs in trade allocation regardless of price improvement by competing Market Makers, the proposal discriminates against non-LMM Market Makers in violation of Section 6(b)(5) of the Exchange Act.3 Therefore, the Phlx respectfully requests that, unless the rule filing is withdrawn or amended by PCX to cure the deficiencies discussed herein, the Commission commence disapproval proceedings under Section 19(b)(2)(B) of the Exchange Act.4
Although the Exchange Act does not mandate a particular market structure, it does set forth certain findings that must be made by the Commission when determining whether to approve proposed rule changes of an SRO. In particular, Section 6(b)(8) of the Exchange Act provides that the rules of an exchange must not "impose any burden on competition not necessary or appropriate in furtherance of the purposes of [the Exchange Act]."5 In addition, Section 6(b)(5) of the Exchange Act provides that the rules of an exchange must be "designed to promote just and equitable principles of trade, . . . remove impediments to and perfect the mechanism of a free and open market and a national market system . . . and not designed to permit unfair discrimination between customers, issuers, brokers, or dealers . . ."6 In addition to the specific requirements applicable to exchange rules, the Commission is required to consider certain Congressionally-mandated goals in facilitating the establishment of a national market system. Among these goals, which are contained in Section 11A of the Exchange Act, is to assure "fair competition among brokers and dealers."7
As currently proposed, the Phlx believes that the PCX Plus system does not meet these basic statutory standards. In our view, the proposal is inconsistent with Sections 11A, 6(b)(8), and 6(b)(5) of the Exchange Act, and inappropriately burdens competition, because it is characterized by an algorithm for trade allocation that would make it virtually impossible for non-LMM Market Makers to compete for trade allocation through competitive quoting, and would overwhelmingly favor highly capitalized LMMs over other market makers. In fact, it is very likely that, in the long-run, use of the trade allocation methodology underlying the PCX Plus system would make it impossible for non-LMMs to survive in the PCX marketplace.8
The proposed PCX Plus market structure is a clear attempt by the PCX to attract order flow - order flow gained not by improving the quality of its market, but by making it more economical for LMMs to purchase order flow. Under the proposal, LMMs would be systematically entitled to receive a larger percentage of each inbound order due to the operation and interaction of the so-called First Improved Quote ("FIQ") and Size Pro Rata trade allocation methods (described below). The Phlx does not believe that this is consistent with the purposes of the Exchange Act or with the maintenance of fair and orderly listed options markets. Moreover, if the Commission approves the trade allocation methods proposed in PCX Plus, there will most certainly be other markets that follow suit, creating structural inequities among market participants and an overall less competitive listed options market.
The Release provides that a Market Maker who improves the then existing PCX market in a given option series establishes FIQ status and is afforded priority over other Market Makers in that series. However, if the LMM matches the price improving quote within 3 seconds, the Market Maker that established the better price loses its FIQ status and has no priority over any other Market Maker. Because a LMM need only match the price improving quote (as opposed to further improving it), LMMs likely would automate the matching process to ensure that no Market Maker that improves the quote would ever be able to maintain FIQ status. Moreover, because of the other aspects of the PCX Plus allocation methodology that assure LMMs disproportionately larger allocations of trades, the ability of LMMs to displace other market makers will guarantee that LMMs will garner the lion's share of all trade allocations.
For example, if a Market Maker improves the PCX Market by establishing a bid in ABC options for a size of 100 contracts, such Market Maker will have established priority over all other Market Makers and would be entitled to receive 100 contracts from an inbound order executed at that price. If, however, the LMM in that options series matches the Market Maker's bid within 3 seconds for a size of 2000 contracts, the LMM would be entitled to receive 40% of an inbound order and the remaining portion of the LMM's bid may participate in the Size Pro Rata allocation. In this example, if an inbound market or marketable limit order for 100 contracts is received, the LMM would be entitled to receive 40 contracts (40% of 100) plus the Size Pro Rata Share equal to 1960/2060ths of the remaining 60 contracts. Thus, the LMM would be entitled to receive 97 contracts (40 + 57), and the original price improving Market Maker, who bid for 100 contracts in establishing the market, would be entitled to receive a mere 3 contracts, despite having improved the market originally.
Thus, in light of the LMM's ability to match the original price improving Market Maker's bid, remove its FIQ status and receive an increased Size Pro Rata allocation, there appears to be no real incentive for a Market Maker to quote competitively.9 The disincentive for Market Makers to quote competitively is exacerbated, in our view, by the likelihood of an LMM creating an automated matching process to remove FIQ status from price improving Market Makers.
In the example above, the LMM, by merely matching the market established by the original price improving Market Maker within 3 seconds, not only removes that Market Maker's FIQ status, but, by joining that market for a significantly larger number of shares effectively "sizes out" the price improving Market Maker. By creating an algorithm that awards the LMM 40% of an eligible inbound order and also allowing the remaining portion of the LMM's bid or offer to participate in the Size Pro Rata allocation, the lesser capitalized Market Maker would have virtually no opportunity to receive an allocation, despite improving the PCX market.
In fact, the algorithm could result in the LMM getting a greater percentage than the PCX guaranteed percentage for LMMs on parity with other crowd participants, despite the Commission's ongoing efforts to limit the allocation percentage guaranteed to specialists and LMMs.10 This trade allocation algorithm simply awards contracts to the matching (not even price-improving) LMM bidding for a large number of contracts, and would allocate contracts first to the LMM, and then to Market Makers with smaller sizes.11 As a result, we believe that there is simply no incentive for Market Makers, other than LMMs, to quote competitively on the basis of price.
Moreover, the PCX's new class of Market Maker - the Supplemental Market Maker ("SMM") - is specifically prohibited by rule from competing with LMMs on the basis of price. The Phlx strongly believes that ultimately the only non-LMMs remaining on the floor of the PCX will be passive, non-competitive SMMs, whose contribution to price competition in an options auction market is questionable at best.
By systematically preferring LMMs in the trade allocation process, the main effect of PCX Plus will be to lower the effective cost of doing business for the LMMs who have to purchase order flow from Order Flow Providers. This may make PCX more attractive to LMMs, but at what cost to the structure of the options markets and the National Market System?
The creation of an algorithm for trade allocation that will systematically make it impossible for Market Makers other than LMMs to compete for trade allocation by way of quote competition and will overwhelmingly favor highly capitalized LMMs over other market makers is contrary to the function and purposes underlying the development and implementation of a National Market System. The PCX proposal, in our view, is inconsistent with Sections 11A, 6(b)(8), and 6(b)(5) of the Exchange Act by imposing burdens on competition that ultimately will result in inferior execution prices for customers and by unfairly discriminating against PCX Market Makers that are not LMMs.
In order to preserve the principle of assuring fair competition among brokers and dealers that is embodied in the Exchange Act and that is at the core of the national market system, we urge the Commission to commence disapproval proceedings for PCX Plus under Section 19(b)(2)(B) of the Exchange Act, by December 16, 2002, unless the PCX withdraws the proposal or amends the proposal to cure the deficiencies discussed herein.
* * * *
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.
Meyer S. Frucher
Chairman and Chief Executive Officer
Harvey L. Pitt, Chairman|
Paul S. Atkins, Commissioner
Roel C. Campos, Commissioner
Cynthia A. Glassman, Commissioner
Harvey J. Goldschmid, Commissioner
Annette Nazareth, Director, Division of Market Regulation
Robert Colby, Deputy Director, Division of Market Regulation
Alden Adkins, Associate Director, Division of Market Regulation
Elizabeth King, Associate Director, Division of Market Regulation
|1||15 U.S.C 78a et seq.|
|2||15 U.S.C. 78f(b)(8).|
|3||15 U.S.C. 78f(b)(5).|
|4||15 U.S.C. 78s(b)(2)(B).|
|5||15 U.S.C. 78f(b)(8).|
|6||15 U.S.C. 78f(b)(5). We also note that Section 3(f) of the Act requires that the Commission consider, in addition to the protection of investors, whether an SRO's proposed rule change will promote efficiency, competition and capital formation. 15 U.S.C 78c(f).|
|7||15 U.S.C. 78k-1.|
|8||The PHLX also questions whether the PCX Plus system is consistent with the Order Instituting Public Administrative Proceedings Pursuant to Section 19(h)(1) of the Securities Exchange Act of 1934, Making Findings and Imposing Sanctions, Securities Exchange Act Release No. 43268 (September 11, 2000) and Administrative Proceeding File 3-10282 (the "Order"), which required, among other things, that the respondent exchanges (including PCX) adopt new, or amend existing, rules concerning its automated quotation systems which substantially enhance incentives to quote competitively and substantially reduce disincentives for market participants to act competitively (the "Competitive Quoting Undertaking").|
|9||The PHLX notes that its "ROT Access" system, filed pursuant to the Competitive Quoting Undertaking in the Order, allows specialists and Registered Options Traders ("ROTs") to match price-improving orders via Auto-Quote or Specialized Quote Feed, but does not remove the "Special Priority" from the original price-improving member. The price-improving member is still entitled to receive the most contracts (60% or 40%) in the "Special Allocation," and the specialist is entitled to receive 30% or 40%, depending on the number of crowd participants on parity. See Securities Exchange Act Release No. 46763 (November 1, 2002), 67 FR 68898 (November 13, 2002) (SR-Phlx-2002-04). Thus, the PHLX ROT Access system does not, in our view, suffer from the same competition defect as the proposed PCX Plus System.|
|10||See Securities Exchange Act Release No. 43100 (July 31, 2000) (Notice of Filing of SR-Phlx-00-01). This proposal would have amended Phlx Rule 1014(g) to entitle a specialist to a higher participation in Top 100 Options. The amendments would have entitled a specialist on parity to an enhanced participation of: (1) 80% in Top 100 options allocated to a specialist after January 1, 1997; and (2) 50% in Top 100 options allocated to a specialist before January 1, 1997. In soliciting comment on the proposal, the Commission indicated that it had "serious concerns" as to whether the proposed changes were consistent with Act, noting particularly the "potential impact that specialist guarantees of up to 80% could have upon competition in the options markets." Phlx notes that, even in this proposal, the specialist would only be entitled to receive an Enhanced Specialist Participation where he was on parity with Registered Options Traders ("ROTs") at the best bid or offer. It did not entitle the specialist to receive any trade allocation where an ROT has clearly established a better bid or offer prior to the specialist, and did not enable the specialist to be on parity with such ROT by later "matching" such ROT's prior bid or offer. Thus, even under this proposal, market makers would have had more incentive to quote competitively than in the proposed PCX Plus system.|
|11||This is contrary to a PHLX proposal, submitted in response to the Order, which allocates contracts to crowd participants with smaller sizes first. See SR-Phlx-2001-39.|