# Proposed Amendments to Rule 610 of Regulation NMS > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2010-9016 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** April 20, 2010 - **Citation:** 75 FR 20738 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 242 [Release No. 34-61902; File No. S7-09-10] RIN 3235-AK62 Proposed Amendments to Rule 610 of Regulation NMS AGENCY: Securities and Exchange Commission (“Commission”). ACTION: Proposed rule. SUMMARY: The Commission is publishing for comment proposed amendments to Rule 610 under the Securities Exchange Act of 1934 (“Exchange Act”) relating to access to quotations in listed options as well as fees for such access. The proposed rule would prohibit an exchange from imposing unfairly discriminatory terms that inhibit efficient access to quotations in a listed option on its exchange and establish a limit on access fees that an exchange would be permitted to charge for access to its best bid and offer for listed options on its exchange. DATES: Comments should be received on or before June 21, 2010. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); or • Send an e-mail to rule-comments@sec.gov. Please include File No. S7-09-10 on the subject line; or • Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File No. S7-09-10. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: Jennifer Colihan, Special Counsel, at (202) 551-5642; Edward Cho, Special Counsel, at (202) 551-5508; or Brian O'Neill, Special Counsel, at (202) 551-5643, Division of Trading and Markets (“Division”), Commission, 100 F Street, NE., Washington, DC 20549-6628. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction II. Proposed Amendments to Rule 610(a) III. Access Fees IV. Technical Amendments to Rule 610 V. Request for Comments VI. Paperwork Reduction Act VII. Consideration of Costs and Benefits VIII. Consideration of Burden on Competition and Promotion of Efficiency, Competition, and Capital Formation IX. Consideration of Impact on the Economy X. Regulatory Flexibility Act Certification XI. Statutory Authority I. Introduction The Commission is proposing to strengthen the national market system for listed options by: (1) Prohibiting the imposition of unfairly discriminatory terms by a national securities exchange that inhibit efficient access to quotations in a listed option on its exchange; and (2) establishing a limit on the amount a national securities exchange would be permitted to charge to access the best bid or offer for listed options on its exchange. These proposed amendments would make the requirements for access to the listed options exchanges comparable to the requirements for access to markets that trade NMS stocks. 1 Further, they would address concerns expressed by certain market participants regarding access to options exchanges. 2 1 See 17 CFR 242.610. 2 See infra Section I.B and notes 34-40 and accompanying text. A. Background In 1975, Congress determined that the “linking of all markets” through communications and data processing facilities would “foster efficiency; enhance competition; increase the information available to brokers, dealers, and investors; facilitate the offsetting of investors' orders; and contribute to the best execution of investors' orders.” 3 As such, Congress directed the Commission, through the enactment of Section 11A of the Exchange Act, to facilitate the establishment of a national market system (“NMS”) to link together the multiple individual markets that trade securities. Congress intended the Commission to take advantage of opportunities created by new data processing and communications technologies to preserve and strengthen the securities markets. 3 See Section 11A(a)(1)(D) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(D). As previously recognized by the Commission, for the NMS to fulfill its statutory objectives, fair and efficient access to each of the individual markets that participate in the NMS is essential. 4 One of the statutory NMS objectives, for example, is to assure the practicability of brokers executing investors' orders in the best market. 5 Another is to assure the efficient execution of securities transactions. 6 Neither of these objectives can be achieved if brokers cannot fairly and efficiently route orders to execute against the best quotations, wherever such quotations are displayed in the NMS. 7 4 See Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) (“NMS Adopting Release”) at 37538. 5 See Section 11A(a)(1)(C)(iv) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C)(iv). 6 See Section 11A(a)(1)(C)(i) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C)(i). 7 See NMS Adopting Release, supra note 4, at 37548. The Commission believes that intermarket price protection is essential in a marketplace such as that for listed options where multiple exchanges trade the same securities. 8 For this reason, the Commission in 1999 ordered the exchanges to jointly develop an NMS linkage plan for listed options. 9 The first such NMS plan, which began operation in 2002 (“2002 Linkage Plan”), included a requirement that its participant exchanges avoid trading through 10 better priced quotations displayed on other options exchanges and disseminated pursuant to the Options Price Reporting Authority Plan (“OPRA Plan”), as well as a mechanism by which participating exchanges could seek satisfaction if an order was traded through. 11 In August 2009, the options exchanges implemented a new NMS plan (“Plan”), 12 approved by the Commission, which specifically requires that each participating exchange establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trading through better priced quotations displayed on other options exchanges and disseminated pursuant to the OPRA Plan (“trade-throughs”). 13 Rule 608(c) of Regulation NMS requires the options exchanges to comply with the terms of the Plan and to enforce compliance with the Plan by their members and persons associated with their members, absent reasonable justification or excuse. 14 Further, each exchange adopted rules to implement the Plan that prohibit members from effecting trade-throughs, subject to certain enumerated exceptions. 15 The approach to trade-throughs under the Plan is similar to that taken by the Commission under Rule 611 of Regulation NMS, which requires that a trading center establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution of trades at prices inferior to protected quotations in NMS stocks displayed by other trading centers, subject to applicable exceptions. 16 8 Eight exchanges currently offer options trading facilities and another exchange is anticipated to begin operations shortly. See Securities Exchange Act Release No. 61152 (December 10, 2009), 74 FR 66699 (December 16, 2009) (order approving C2 Options Exchange's application for registration as a national securities exchange). 9 See Securities Exchange Act Release No. 42029 (October 19, 1999), 64 FR 57674 (October 26, 1999). 10 A “trade-through” was defined as a transaction in an options series at a price that is inferior to the NBBO, but shall not include a transaction that occurs at a price that is one minimum quoting increment inferior to the NBBO provided a Linkage Order is contemporaneously sent to each Participant disseminating the NBBO for the full size of the Participant's bid (offer) that represents the NBBO. See Section 2(29) of the 2002 Linkage Plan. “NBBO” was defined as the national best bid and offer in an options series calculated by a Participant. See Section 2(18) of the 2002 Linkage Plan. 11 See Securities Exchange Act Release No. 43086 (July 28, 2000), 65 FR 48023 (August 4, 2000) (order approving 2002 Linkage Plan). The OPRA Plan is a national market system plan approved by the Commission pursuant to Section 11A of the Exchange Act and Rule 608 thereunder. See Securities Exchange Act Release No. 17638 (March 18, 1981), 22 S.E.C. Docket 484 (March 31, 1981). 12 This new Plan was designed, in part, to apply the Regulation NMS price-protection provisions to the options exchanges. See letter from Michael J. Simon, International Securities Exchange LLC (“ISE”), to Nancy M. Morris, Secretary, Commission, dated September 12, 2007, at 2-3. 13 See Securities Exchange Act Release No. 60405 (July 30, 2009), 74 FR 39362 (August 6, 2009) (“Plan Approval Order”) and Section 5(a) of the Plan. A “trade-through” is defined in this new Plan as a transaction in an option series, either as principal or agent, at a price that is inferior to the best bid or offer in an option series that is displayed by an exchange, and is disseminated pursuant to the OPRA Plan. See Sections 2(1), 2(6), 2(14), 2(17), and 2(21) of the Plan. 14 See 17 CFR 242.608(c). 15 See, e.g., ISE Rule 1901, NYSE Arca, Inc. (“NYSE Arca”) Rule 6.94, and NASDAQ OMX PHLX, Inc. (“Nasdaq OMX Phlx”) Rule 1084. Prior to the adoption of the new Plan, the options exchanges had in place rules addressing trade-throughs as required under the 2002 Linkage Plan. The exchanges revised these rules following the adoption of the new Plan to reflect the trade-through requirements in the new Plan. 16 17 CFR 242.611(a). To be protected, a quotation must be immediately and automatically accessible. See 17 CFR 242.600(b)(58) (defining the term “protected quotation” as any protected bid or protected offer); see also 17 CFR 242.600(b)(57). The term “protected bid” or “protected offer” means a quotation in an NMS stock that is displayed by an automated trading center, is disseminated pursuant to an effective national market system plan, and is an automated quotation that is the best bid or best offer of a national securities exchange, the best bid or best offer of The Nasdaq Stock Market, Inc., or the best bid or best offer of a national securities association other than the best bid or best offer of The Nasdaq Stock Market, Inc. To satisfy the requirements of the trade-through provisions of the Plan and the exchanges' rules 17 (collectively referred to as “Trade-Through Rules”), an options exchange with a best bid or best offer that is inferior to another exchange's best quotation may choose to handle a pending incoming marketable order by: (1) Cancelling the order; (2) routing the order to another exchange displaying a better price; 18 or (3) providing an opportunity for its members, on their own behalf or on behalf of other market participants, to “step up” and trade with the order at a price at least equal to the better displayed price on an away exchange. 19 17 See Section 5(a) of the Plan; see also, e.g., ISE Rule 1901, NYSE Arca Rule 6.94 and Nasdaq OMX Phlx Rule 1084. 18 To implement the choice of routing to another exchange to access a better-priced quotation, the options exchanges currently use private routing arrangements that provide for indirect access to quotations displayed by a particular options exchange through the members of that exchange. The Commission has stated its belief that the use of private linkages for routing will allow the exchanges to take advantage of new technology that allows for efficient routing and executions, and will give the exchanges greater flexibility for order handling. See Plan Approval Order, supra note 13, at 39364. The options exchanges complied with the requirements of the prior linkage plan by utilizing a stand alone system (“centralized hub”) to send and receive specific order types. The centralized hub was a centralized data communications network that electronically linked the options exchanges to one another. The Options Clearing Corporation (“OCC”) operated the centralized hub. See id. 19 The Commission separately has proposed changes to Rule 602 of Regulation NMS that may affect these electronic “step-up” mechanisms, if adopted. See Securities Exchange Act Release No. 60684 (September 18, 2009), 74 FR 48632, 48633 (September 23, 2009) (File No. S7-21-09) (“Flash Order Proposal”). See infra notes 72-75 and accompanying text. In addition, broker-dealers have a duty of best execution. 20 A broker-dealer must carry out a regular and rigorous review of the quality of the options markets to evaluate its best execution policies, including the determination as to which options market it routes customer order flow. 21 The protection against trade-throughs undergirds the broker-dealer's duty of best execution by helping ensure that customer orders are not executed at prices inferior to the best quotations, but does not supplant or diminish the broker-dealer's responsibility for achieving best execution, including its duty to evaluate the execution quality of markets to which it routes customer orders. 22 20 A broker-dealer has a legal duty to seek to obtain best execution of customer orders. See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 269-70, 274 (3d Cir.), cert. denied, 525 U.S. 811 (1998); Certain Market Making Activities on Nasdaq, Securities Exchange Act Release No. 40900 (Jan. 11, 1999) (settled case) (citing Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Arleen Hughes, 27 SEC 629, 636 (1948), aff'd sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949)). See also Order Execution Obligations, Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996) (“Order Handling Rules Release”). A broker-dealer's duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated in SRO rules and, through judicial and Commission decisions, the antifraud provisions of the federal securities laws. See Order Handling Rules Release, 61 FR at 48322. See also Newton, 135 F.3d at 270. The duty of best execution requires broker-dealers to execute customers' trades at the most favorable terms reasonably available under the circumstances, i.e., at the best reasonably available price. Newton, 135 F.3d at 270. Newton also noted certain factors relevant to best execution—order size, trading characteristics of the security, speed of execution, clearing costs, and the cost and difficulty of executing an order in a particular market. Id. at 270 n.2 (citing Payment for Order Flow, Exchange Act Release No. 33026 (Oct. 6, 1993), 58 FR 52934, 52937-38 (Oct. 13, 1993) (Proposed Rules)). See In re E.F. Hutton & Co., Securities Exchange Act Release No. 25887 (July 6, 1988). See also Securities Exchange Act Release No. 34902 (October 27, 1994), 59 FR 55006, 55008-55009 (November 2, 1994) (“Approval of Payment for Order Flow Final Rules”). See also NMS Adopting Release, supra note 4, at 37537 (discussing the duty of best execution). 21 See Securities Exchange Act Release No. 49175 (February 3, 2004), 69 FR 6124, 6128 (February 9, 2004) (“Options Concept Release”). See also NMS Adopting Release, supra note 4, at 37538. 22 See NMS Adopting Release, supra note 4, at 37538. These regulatory obligations mean that broker-dealers responsible for routing customer orders, as well as customers making their own order-routing decisions, must have fair and efficient access to the best displayed quotations to achieve best execution of those orders, and the exchanges themselves must have the ability to execute orders against the displayed quotations of other exchanges. 23 Moreover, the benefits of intermarket price protection could be compromised if exchanges were able to charge substantial fees for accessing their quotations. 24 23 See id. at 37539. 24 See id. at 37544. Further, the Exchange Act authorizes the Commission to adopt rules assuring the fairness and usefulness of quotation information. 25 The wider the disparity in the level of fees among the different exchanges, the less useful and accurate are the displayed prices. For example, if two options exchanges displayed quotations to sell an option for $10.00 per contract, one exchange offer could be accessible for a total price of $10.00 per contract plus a $0.50 per contract access fee, while the second exchange might not charge any such access fee. What appeared in the consolidated data stream to be identical quotations would in fact not be identical in terms of all-in costs. The Commission recognizes that there may be different ways to achieve the objective of fair and useful quotations. One approach is to limit the extent to which the all-in price for those who access quotations can vary from the displayed price by limiting fees for accessing those quotations, as proposed here in Rule 610(c)(2). 26 25 See Section 11A(c)(1)(B) of the Exchange Act, 15 U.S.C. 78k-1(c)(1)(B). 26 See NMS Adopting Release, supra note 4, at 37545 (stating that for quotations to be fair and useful there must be some limit on the extent to which the true price for those who access quotations can vary from the displayed price). An access fee limit also creates more transparency in the cost of accessing quoted prices. Currently, there are so many different fees across options exchanges, across different categories of options participants, and across different product types, that it is not easy to estimate the total cost of executing against a quotation for a particular transaction. An access fee cap would provide clearer information on the maximum cost for accessing quoted prices. The Commission recognizes, however, that although a cap on access fees would promote the fairness and usefulness of displayed quotations and transparency in the cost of assessing quoted prices, there may be other fees assessed that would not be included in the proposed cap on access fees. B. Overview of Current Options Market Structure In the listed options market, all orders are currently executed on registered national securities exchanges. Options exchanges have, to date, adopted one of two general business models. An exchange using the first model—referred to as the “Make or Take” model—incents market participants to quote aggressively by providing a rebate to an order or quotation displayed on its exchange when such order or quotation is executed. This rebate is funded through the fee charged to the order that executed against the displayed order or quotation. The difference between the fee charged for accessing the order or quotation and the rebate is revenue to the exchange. NYSE Arca was the first options exchange to implement the Make or Take transaction fee model. 27 The introduction of the Make or Take model followed the reduction of the quoting increment in certain options in 2007. 28 As of February 1, 2010, market participants could represent trading interest in penny increments in options series in 211 specified classes. These classes represent approximately 69.5 percent of trading volume. By August 2, 2010, 361 classes will be included in the Minimum Quoting Increment Pilot Program, representing approximately 88.1 percent of trading volume during February 2010. 29 27 See Securities Exchange Act Release No. 55223 (February 1, 2007), 72 FR 6306 (February 9, 2007) (SR-NYSEArca-2007-07). The NASDAQ Options Market LLC (“NOM”) also uses a “Make or Take” fee model for certain options classes. See The NASDAQ Options Market: Execution and Routing Fees (available at http://www.nasdaqtrader.com/content/ProductsServices/PriceList/nasdaq_options_pricing.pdf ) (current as of December 1, 2009). 28 On January 26, 2007, the then-existing six options exchanges implemented a pilot program to quote certain options series in thirteen classes in one-cent increments (“Minimum Quoting Increment Pilot Program”). The NASDAQ Stock Market LLC (“Nasdaq”) became a participant in the Minimum Quoting Increment Pilot Program on March 31, 2008, when it commenced trading on NOM, and BATS Exchange, Inc. (“BATS”) became a participant in the Minimum Quoting Increment Pilot Program on February 26, 2010 when it commenced trading on BATS Options Exchange Market. Since 2007, the Minimum Quoting Increment Pilot Program has been extended and expanded several times. See, e.g., Securities Exchange Act Release Nos. 56276 (August 17, 2007), 72 FR 47096 (August 22, 2007) (SR-CBOE-2007-98); 56567 (September 27, 2007), 72 FR 56396 (October 3, 2007) (SR-Amex-2007-96); 57579 (March 28, 2008), 73 FR 18587 (April 4, 2008) (SR-Nasdaq-2008-026); 60711 (September 23, 2009), 74 FR 49419 (September 28, 2009) (SR-NYSEArca-2009-44); and 61061 (November 24, 2009), 74 FR 62857 (December 1, 2009) (SR-NYSEArca-2004-44). 29 The source of the data is OptionsMetrics, LLC (“OptionsMetrics”). The data used for the estimates corresponds to February 2010. By August 2010, the Minimum Quoting Increment Pilot Program will incorporate 150 additional classes. Those classes will be incorporated according to volume levels on the month before the expansion. For the current approximation, Commission staff projected which classes would be added by August 2010 using volume data corresponding to February 2010. On an exchange with a “Make or Take” fee model, broker-dealers representing customer orders must pay a “Take” fee to access a displayed quotation on that exchange. In contrast, on an exchange without that fee model, broker-dealers generally are not assessed a similar fee when a customer order is executed. This distinction brought attention to the issue of whether, and to what extent, access fees impact fair and efficient access to displayed quotations in listed options. Exchanges using the second model—referred to as the “Broker Payment” model—generally charge no or low fees for the execution of customers' orders. 30 However, these exchanges often charge other types of fees on a per-transaction basis. For example, most options exchanges charge a surcharge or “royalty” fee for executions in certain index option classes. 31 Many exchanges also charge a payment for order flow or “marketing” fee to market makers that trade with customer orders on the exchange. 32 The exchange then makes the proceeds from such fees available to collectively fund payment for order flow to brokers directing order flow to the exchange. 33 30 Exchanges that use the “Broker Payment” model also generally give priority to customer orders at the best price over other orders or quotations at that price. After customer orders are executed, the rules of “Broker Payment” options exchanges dictate how the remainder of an incoming order is allocated against resting non-customer orders or quotations. ISE, for example, requires that priority be given to public customer orders, and provides for pro-rata allocation among non-customer orders and quotations. See Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 11388, 11395 (March 2, 2000) (order approving the registration of the International Securities Exchange LLC as a national securities exchange (“ISE Exchange Approval”)). Exchanges that use a “Broker Payment” model do not give priority to orders from certain customers who are “professional” customers under exchange rules. See Securities Exchange Act Release Nos. 59287 (January 23, 2009), 74 FR 5694 (January 30, 2009) (SR-ISE-2006-26); 61198 (December 17, 2009), 74 FR 68880 (December 29, 2009) (SR-CBOE-2009-078); and 61802 (March 3, 2010) (SR-Phlx-2010-05). “Professional” customers are treated on ISE, the Chicago Board Options Exchange, Incorporated (“CBOE”), and Nasdaq OMX Phlx in the same manner as a broker-dealer for purposes of specified order execution rules, including priority rules. Under these exchange rules, “Professional” customers participate in ISE's, CBOE's, and Nasdaq OMX Phlx's allocation processes on equal terms with broker-dealers, i.e., they do not receive priority over broker-dealers in the allocation of orders on the exchange. Several exchanges have, however, begun to charge transaction fees to certain customers identified in exchange rules as “professionals.” See Securities Exchange Act Release Nos. 59287 and 61198. 31 See BOX Fee Schedule, at 1 (available at http://www.bostonoptions.com/pdf/BOX_Fee_Schedule.pdf ) (current as of January 2010); CBOE Fee Schedule, at 1 (available at http://www.cboe.com/publish/feeschedule/CBOEFeeSchedule.pdf ) (current as of February 2, 2010); ISE Fee Schedule, at 6 (available at http://www.ise.com/assets//documents//OptionsExchange//legal/fee/fee_schedule.pdf ) (current as of January 8, 2010); NYSE Amex Fee Schedule, at 3 (available at http://www.nyse.com/pdfs/NYSE_Amex_Options_Fee_Schedule01.04.10.pdf ) (current as of January 4, 2010); NYSE Arca Fee Schedule, at 6 (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010); and Nasdaq OMX Phlx Fee Schedule, at 5 (available at http://www.nasdaqomxtrader.com/content/marketregulation/membership/phlx/feesched.pdf ) (current as of February 24, 2010). 32 See CBOE Fee Schedule, at 2 (available at http://www.cboe.com/publish/feeschedule/CBOEFeeSchedule.pdf ) (current as of February 2, 2010); ISE Fee Schedule, at 6 (available at http://www.ise.com/assets//documents//OptionsExchange//legal/fee/fee_schedule.pdf ) (current as of January 8, 2010); NYSE Amex Fee Schedule, at 3 (available at http://www.nyse.com/pdfs/NYSE_Amex_Options_Fee_Schedule01.04.10.pdf ) (current as of January 4, 2010); NYSE Arca Fee Schedule, at 6 (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010); and Nasdaq OMX Phlx Fee Schedule, at 6 (available at http://www.nasdaqomxtrader.com/content/marketregulation/membership/phlx/feesched.pdf ) (current as of February 24, 2010). 33 See, e.g., Nasdaq OMX Phlx Fee Schedule, at 6, 15 (available at http://www.nasdaqomxtrader.com/content/marketregulation/membership/phlx/feesched.pdf ) (current as of February 24, 2010). See also infra note 109 and accompanying text. In July 2008 the Commission received a Petition for Rulemaking to Address Excessive Access Fees in the Options Markets from Citadel Investment Group, L.L.C. (“Citadel Petition”). 34 In the Citadel Petition, Citadel petitions the Commission to engage in rulemaking to limit the “Take” fees that options exchanges may charge non-members to obtain access to quotations to $0.20 per contract. NYSE Arca also filed a proposal in July 2008 to raise its “Take” fee for certain classes. Specifically, NYSE Arca submitted a proposed rule change for immediate effectiveness that raised its “Take” fee charged to members for certain designated Minimum Quoting Increment Pilot Program issues from $0.45 per contract to $0.55 per contract, and raised the corresponding credit in those same issues from $0.30 per contract to $0.40 per contract for market makers, and from $0.25 per contract to $0.35 per contract for electronically executed broker-dealer and customer orders. 35 The Commission requested comment on the issue of access fees when it published NYSE Arca's proposal for comment. 36 34 See letter from John C. Nagel, Managing Director & Deputy General Counsel, Citadel, to Nancy M. Morris, Secretary, Commission, dated July 15, 2008 (available at http://www.sec.gov/rules/petitions/2008/petn4-562.pdf ). 35 These Pilot issues included: AAPL, CSCO, DIA, MSFT, IWM, QQQQ, RIMM, XLF, SPY, YHOO. See Securities Exchange Act Release No. 58295 (August 4, 2008), 73 FR 46681 (August 11, 2008) (SR-NYSEArca-2008-75). 36 Concurrently, NYSE Arca filed a proposed rule change to increase the fee charged to orders received through the then-existing options linkage in certain Minimum Quoting Increment Pilot Program issues from $0.45 to $0.55 per contract. See SR-NYSEArca-2008-76. The Commission has not published this proposed rule change for notice and comment. Pending Commission action on SR-NYSEArca-2008-76, NYSE Arca has stated that it will not implement its fee changes included in SR-NYSEArca-2008-75. The Commission has received several comment letters in response to its request for comment on the NYSE Arca proposed rule change and to the Citadel Petition, which discuss the issue of access fees and imposing a cap on such fees. 37 The Commission also received several comment letters in response to a proposal to amend Rule 602 of Regulation NMS to effectively ban marketable “flash orders” in NMS securities that discuss the issue of access fees in listed options. 38 Commenters on the Flash Order Proposal expressed concern that eliminating flash orders on the options exchanges would increase direct costs associated with executing customers' listed options orders. 39 The absence of a limit on fees that an options exchange can charge for accessing its quotation was one reason commenters said that banning flash orders would be more detrimental to listed options customers than to cash equity customers. 40 These concerns about the absence of a limit on access fees on the listed options exchanges echo the comments received in response to the Citadel Petition and NYSE Arca's proposal. These comments were considered in developing this proposal and are discussed below. 37 Letters received in response to SR-NYSEArca-2008-75: See letters from John C. Nagel, Managing Director and Deputy General Counsel, Citadel, to Nancy M. Morris, Secretary, Commission, dated July 23, 2008 (“Citadel Letter”); Stephen Schuler and Daniel Tierney, Managing Members, Global Electronic Trading Company to Florence E. Harmon, Acting Secretary, Commission, dated September 2, 2008 (“GETCO Letter”); Christopher Nagy, Managing Director, Order Routing Sales and Strategy, TD Ameritrade, Inc. to Florence E. Harmon, Acting Secretary, Commission, dated September 9, 2008 (“TD Ameritrade Letter”); and Robert R. Bellick, Managing Director, Wolverine to Nancy M. Morris, Secretary, Commission, dated September 10, 2008 (“Wolverine Letter”) (available at http://www.sec.gov/comments/sr-nysearca-2008-75/nysearca200875.shtml ). Letter received in response to the Citadel Petition: See letter from Lawrence Leibowitz, Group Executive Vice President and Head of Global Execution and Technology, NYSE Euronext, to Florence E. Harmon, Acting Secretary, Commission, dated September 3, 2008 (“NYSE Euronext Letter”) (available at http://www.sec.gov/comments/4-562/4-562.shtml ). Letters received in response to both the Citadel Petition and SR-NYSEArca-2008-75: See letters from David M. Battan, Executive Vice President, Interactive Brokers Group LLC, to Florence Harmon, Acting Secretary, Commission, dated September 8, 2008 (“IB Letter”); and William Easley, Vice Chairman, Boston Options Exchange (“BOX”) to Florence E. Harmon, Acting Secretary, Commission, dated September 11, 2008 (“BOX Letter”) (available at http://www.sec.gov/comments/sr-nysearca-2008-75/nysearca200875.shtml ). Letters received in response to SR-NYSEArca-2009-44, which proposed to expand the number of classes eligible to participate in the Minimum Quoting Increment Pilot: See letters from Christopher Nagy, Managing Director, Order Routing Strategy, TD Ameritrade, Inc. to Elizabeth M. Murphy, Secretary, Commission, dated June 17, 2009 (“TD Ameritrade Letter II”) and December 1, 2009 (“TD Ameritrade Letter III”) (available at http://www.sec.gov/comments/sr-nysearca-2009-44/nysearca200944.shtml ). 38 See Flash Order Proposal, supra note 19. A “flash order” generally is any order qualifying for the “immediate execution or withdrawal” exception from Rule 602. For more detail about the basic features that define flash orders, see the Flash Order Proposal. Flash orders allow options exchanges that charge no or low fees to execute customer orders to “step up” and match better displayed quotations on other exchanges. 39 See, e.g., letters from Christopher Nagy, Managing Director, Order Routing Strategy, TD Ameritrade, Inc., to Elizabeth M. Murphy, Secretary, Commission, dated November 23, 2009 (“Ameritrade Flash Letter”); letter from John C. Nagel, Managing Director and Deputy General Counsel, Citadel, to Elizabeth M. Murphy, Secretary, Commission, dated November 20, 2009 (“Citadel Letter II”); Peter Bottini, EVP Trading and Customer Service, and Hillary Victor, Associate General Counsel, optionsXpress, to Elizabeth M. Murphy, Secretary, Commission, dated November 25, 2009 (“optionsXpress Flash Letter”); Thomas F. Price, Managing Director, Securities Industry Financial Association, to Elizabeth M. Murphy, Secretary, Commission, dated December 1, 2009 (“SIFMA Flash Letter”) (available at http://www.sec.gov/comments/s7-21-09/s72109.shtml ). 40 See SIFMA Flash Letter, supra note 39, at 5. See also Citadel Letter II, infra note 39, at 1-2; Ameritrade Flash Letter, supra note 39, at 3; and optionsXpress Flash Letter, supra note 39, at 6. II. Proposed Amendments to Rule 610(a) Access to displayed quotations, particularly the best quotations of an exchange or association, is vital for the smooth functioning of intermarket trading. 41 Brokers responsible for routing their customers' orders, as well as investors that make their own order-routing decisions, must have fair and efficient access to the best displayed quotations of all options exchanges to achieve best execution of those orders. In addition, options exchanges themselves must have the ability to route orders for execution against the displayed quotations of other exchanges. Indeed, the concept of intermarket protection against trade-throughs is premised on the ability of options exchanges to trade with, rather than trade through, the quotations displayed by other options exchanges. 42 41 See NMS Adopting Release, supra note 4, at 37539. Currently, no national securities association quotes or trades listed options. 42 See id. Currently, Rule 610(a) furthers the goal of fair and efficient access to quotations primarily by prohibiting a national securities exchange or national securities association from imposing unfairly discriminatory terms that prevent or inhibit any person from obtaining efficient access through a member of the national securities exchange or national securities association to any quotations in an NMS stock 43 displayed by the exchange or association. 44 This anti-discrimination standard is designed to support indirect access by persons to quotations in NMS stocks through members, and is premised on fair and efficient access of exchange or association members themselves to the quotations in NMS stocks. 45 43 See Rule 600(b)(47), 17 CFR 242.610(b)(47) (defining NMS stock as any NMS security other than an option). See also Rule 600(b)(46), 17 CFR 242.610(b)(46) (defining NMS security as any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options). 44 See Rule 610(a), 17 CFR 242.610(a). See also NMS Adopting Release, supra note 4, at 37539. 45 See NMS Adopting Release, supra note 4, at 37502. The Commission is proposing to amend Rule 610(a) to extend this prohibition to NMS securities, 46 which include listed options as well as NMS stocks. The proposal to extend the anti-discrimination standard in Rule 610(a) to the trading of listed options is designed to support indirect access by persons to quotations in listed options through members. Like current Rule 610(a), the proposed amendment is premised on the need for fair and efficient access of members themselves to the quotations of the exchange in listed options. 46 See supra note 43 (defining NMS security). Market participants can either become members of an exchange to obtain direct access to its options quotations, or they can obtain indirect access by “piggybacking” on the direct access of members. Access to exchanges currently is addressed by several provisions of the Exchange Act. 47 In particular, Section 6(b)(5) of the Exchange Act requires in part that the rules of an exchange not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers. 48 The proposed amendments to Rule 610(a) would build on this existing access structure, including the prohibition in Section 6(b)(5) against unfair discrimination, by specifically prohibiting unfair discrimination that prevents or inhibits non-members from “piggybacking” on the access of members. The ability to fairly and efficiently obtain indirect access through a member is necessary to assure that non-members can readily access quotations in options to meet the requirements of the Trade-Through Rules and to fulfill the non-members' duty of best execution. 49 47 Section 6(b)(4) of the Exchange Act requires the rules of an exchange to provide for the equitable allocation of reasonable dues, fees, and other charges among its members and other persons using its facilities, while Section 6(b)(5) of the Exchange Act requires in part that its rules not be designed to permit unfair discrimination between customers, brokers, or dealers. Section 6(b)(5) also requires an exchange to have rules designed to remove impediments to, and perfect the mechanism of, a free and open market and a national market system. In addition, Section 6(b)(1) of the Exchange Act requires that an exchange must have the capacity to be able to carry out the purposes of the Exchange Act. See 15 U.S.C. 78f(b)(4); 15 U.S.C. 78f(b)(5); 15 U.S.C. 78f(b)(1). Section 11A(a)(1)(C) of the Exchange Act provides that two of the objectives of a national market system are to assure the economically efficient execution of securities transactions and the practicability of brokers executing investors' orders in the best market. See 15 U.S.C. 78k-1(a)(1)(C). 48 The requirements of Section 6(b)(5) of the Exchange Act apply to any rule of an exchange, and as such are not limited to access through members of an exchange to the quotations of that exchange. 49 See supra notes 4-22 and accompanying text. The Commission does not believe that, if it were to prohibit exchanges from imposing unfairly discriminatory terms on non-members who obtain indirect access to quotations in options through members, it would require exchanges to provide non-members with free access to such quotations. Members who provide piggyback access to non-members would be providing a useful service and presumably would charge a fee for such service. The fee would be subject to competitive forces and likely would reflect the costs of membership, plus some element of profit to the members. As a result, non-members that frequently make use of indirect access are likely to contribute indirectly to cover the costs of membership in the market. In addition, the unfair discrimination standard of Rule 610(a) as proposed to be amended would apply only to access to quotations in NMS securities, including options. All other services would be subject to the more general fair access provisions applicable to national securities exchanges, as well as the statutory provisions that govern their respective rules. 50 50 See NMS Adopting Release, supra note 4, at 37540. On the other hand, any attempt by an options exchange to charge differential fees based solely on the non-member status of a person obtaining indirect access to its quotations would violate Rule 610(a) as proposed to be amended. 51 As noted above, fair and efficient access to quotations is essential to the functioning of the NMS. 52 For example, if an exchange charges discriminatory fees to non-members to access its quotations, this practice would interfere with the functioning of the private linkage approach and detract from its usefulness to exchanges in meeting their required responsibilities under the Trade-Through Rules. Fair and efficient access to the best quotations is also necessary for brokers to achieve best execution of orders. 53 Accordingly, the Commission is proposing to amend Rule 610(a) to establish baseline intermarket access rules for options markets to promote indirect access to such markets by a non-member through a member. 51 Id. For example, the Commission preliminarily believes an exchange that charges a non-member broker-dealer that is registered as an options market maker on another exchange a higher fee than the fee charged to both member and non-member broker-dealers that also are not market makers on that exchange for obtaining access to its quotations would violate Rule 610(a), as proposed to be amended. 52 See supra notes 4-7 and accompanying text. 53 See NMS Adopting Release, supra note 4, at 37539. See also supra notes 20-22 and accompanying text. The prohibition on imposing unfairly discriminatory terms in Rule 610(a) currently applies to terms that prevent or inhibit efficient access to quotations. The term “quotation” is defined in Rule 600(a)(62) of Regulation NMS as a bid or offer, and “bid” or “offer” is defined in Rule 600(b)(8) of Regulation NMS as the bid price or the offer price communicated by a member of a national securities exchange or national securities association to any broker or dealer or to any customer. 54 Rule 610(a), therefore, applies to the entire depth of book of displayed orders in NMS stocks, including reserve size 55 and displayed size at each price. 56 The Commission's proposal to extend Rule 610(a) to all NMS securities so that listed options markets are covered by the Rule would apply in the same manner. 57 Thus, options markets would be prohibited from imposing unfairly discriminatory terms that prevent or inhibit efficient access to the entire depth of book of displayed orders. 54 See 17 CFR 242.600(b)(62) and 17 CFR 242.600(b)(8). 55 “Reserve size” generally means an undisplayed portion of an order. Once the displayed size of an order is executed against, the reserve size is used to refresh the market participant's displayed size. See, e.g., NYSE Arca Rule 6.62(d)(3) and ISE Rule 2104(n). 56 See NMS Adopting Release, supra note 4, at 37548. 57 The Commission notes that, although fees are the most likely way in which an exchange could discriminate against non-members for access to its quote, the Commission's proposal would more broadly prohibit any unfairly discriminatory terms. III. Access Fees A. Proposed Rule 610(c)(2) Generally, the Commission believes that market forces and the dynamics of competition should determine the level of exchange fees whenever possible. 58 As discussed below, however, the Commission is concerned that because of the requirements for intermarket price protection, competitive forces, by themselves, are not, and will not be, enough to prevent fees from being charged that interfere with fair and efficient access to an option exchange's displayed prices. 59 Accordingly, the Commission is proposing to impose a limit on the amount of fees that an exchange can impose (or permit to be imposed) for the execution of an order against the exchange's best bid and offer. This proposal also responds to market participants' concerns regarding access fees, 60 as discussed below. 61 58 See Securities Exchange Act Release Nos. 59039 (December 2, 2008), 73 FR 74770, 74781-82 (December 9, 2008) (“NYSE Arca Data Order”) (stating in part that “[t]he Exchange Act and its legislative history strongly support the Commission's reliance on competition, whenever possible, in meeting its regulatory responsibilities for overseeing the SROs and the national market system. Indeed, competition among multiple markets and market participants trading the same products is the hallmark of the national market system.”). 59 See NMS Adopting Release, supra note 4, at 37545 (concluding that imposing a fee limitation was necessary to support the integrity of the price protection requirement established to prevent trade-throughs: “[T]he adopted fee limitation is designed to preclude individual trading centers from raising their fees substantially in an attempt to take improper advantage of strengthened protection against trade-throughs and the adoption of a private linkage regime. In particular, the fee limitation is necessary to address “outlier” trading centers that otherwise might charge high fees to other market participants required to access their quotations by the Order Protection Rule.”). 60 These concerns, as noted above, have been raised by a petition for rulemaking to limit the “Take” fees that options exchanges may charge non-members to access quotations and comment letters in response to this petition and NYSE Arca's proposal to raise its “Take” fee. See Citadel Petition, supra note 34; see also supra note 37. 61 See infra notes 70 and 79 and accompanying text. Each of the options exchanges currently charges market participants fees when incoming orders access their displayed quotations. Although these fees may have different names ( e.g., a “Take” fee versus a transaction fee), and may vary in amount based on the type of account from which the order is sent, these fees all have one thing in common—they are fees triggered by the execution of an incoming order against an order or quotation on that exchange. In particular, on exchanges that use the “Broker Payment” fee model, 62 although orders executed on behalf of customer accounts may not be charged any transaction fees, orders executed on behalf of non-customer accounts are charged transaction fees. 63 In some cases, these fees may be substantial. For example, for options classes not included in the Minimum Quoting Increment Pilot Program, one exchange charges $0.50 per contract for electronically executed orders for the account of a broker dealer or firm, 64 while another exchange charges $0.45 per contract for electronically executed broker-dealer orders. 65 62 See supra notes 30-33 and accompanying text. 63 A customer generally is understood to be a person that is not a broker-dealer. See, e.g., ISE Rule 100(a)(38) (defining the term “public customer”). However, as noted above, some exchanges have begun to charge transaction fees to certain customers identified in exchange rules as “professionals.” See supra note 30. 64 See NYSE Arca Fee Schedule (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010). 65 See CBOE Fee Schedule (available at http://www.cboe.com/publish/feeschedule/CBOEFeeSchedule.pdf ) (current as of February 2, 2010). In addition, on exchanges that use the “Make or Take” fee model, 66 an exchange charges “Take” fees to members that execute orders against that exchange's quotations. These exchanges then pass a substantial portion of that fee back as a rebate to the member that supplied the accessed liquidity ( i.e., market maker quotations or non-marketable limit orders). The “Take” fees charged by these exchanges also can be substantial. For example, for options classes in the Minimum Quoting Increment Pilot Program, one exchange charges $0.45 per contract when an order for the account of a non-customer (and $0.35 per contract when an order for the account of a customer) trades against liquidity on the exchange's book. The exchange then rebates $0.25 per contract to the member (or members) that represented the order (or orders) on its book that provided the liquidity to the incoming order. 67 Another exchange charges a $0.45 per-contract “Take” fee when an order in a Minimum Quoting Increment Pilot Program options class trades with liquidity on the exchange's book. This exchange then rebates $0.30 per contract to an exchange market maker that provided the liquidity to the incoming order and $0.25 per contract to the member that represented a broker-dealer or customer order that provided liquidity to the incoming order. 68 66 See supra note 27 and accompanying text. 67 See Section 1 of Nasdaq Rule 7050 and The NASDAQ Options Market: Execution and Routing Fees (available at http://www.nasdaqtrader.com/content/ProductsServices/PriceList/nasdaq_options_pricing.pdf ) (current as of January 4, 2010). 68 See “Transaction Costs” Section of the NYSE Arca Fee Schedule (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010). See also supra notes 35 and 36 and accompanying text. The Commission believes that the benefits of intermarket price protection and more efficient linkages could be compromised if options exchanges charge substantial fees for accessing their best bids and offers. For this reason, the Commission preliminarily believes that a fee limitation is necessary to support the integrity of the price protection requirement under the Trade-Through Rules. 69 The Commission's views are informed by commenters that argue that a limit on fees for accessing quotations would support the integrity of the rules limiting trade-throughs because a fee limitation would prohibit individual exchanges from raising their fees substantially in an attempt to take improper advantage of protection against trade-throughs. In particular, commenters contend that, in the absence of a fee limit, some exchanges may take advantage of the requirement to protect displayed quotations by charging exorbitant fees to those required to access the exchange's quotations, which could compromise the fairness and efficiency of the NMS for trading standardized options. 70 Although the exchange charging the highest fees likely would be the last exchange to which orders would be routed, prices could not move to the next level until someone routed an order to take out the displayed price at such a high fee exchange. Thus, while exchanges would have significant incentives to compete to be near the top in order-routing priority, arguably there would be little incentive to avoid being the least-preferred exchange if fees were not limited. 71 69 See supra notes 13 and 17-19 and accompanying text for a definition of “Trade-Through Rules.” 70 See Citadel Petition, supra note 34, at 4 (arguing that “Taker” fees are sustained by virtue of the regulatory obligations prohibiting trade-throughs, in that when an exchange is quoting alone at the NBBO, market participants cannot avoid the Taker fees imposed by such exchange, irrespective of how high such fees may be); Citadel Letter II, supra note 37, at 6 (arguing that if the Commission were to ban or limit the use of step-up mechanisms in the options markets, the need for an access fee cap would become essential); TD Ameritrade Letter, supra note 37, at 1 (arguing that Make or Take fees have the potential to create incentives for participants to post liquidity and lock markets to capture the rebate and that other options exchanges would have to increase their fees and rebates in order to defend their market share). See also Wolverine Letter, supra note 37, at 6 (asserting that, while a cap implemented as proposed by Citadel would reduce Take fees charged to non-members who may be forced to access “outlier” markets due to trade through obligations, members would still be forced to pay unrestricted fees); GETCO Letter, supra note 37, at 3 (stating that if the Commission does decide to place caps on access fees charged by exchanges that use the “Make or Take” fee model, it should also cap all-in access fees for traditional exchanges, i.e., those that use the “Broker Payment” fee model, regardless of the type of market participant accessing the exchange's quotation). 71 See NMS Adopting Release, supra note 4, at 37545. The proposed fee limitation is designed to preclude this business practice by limiting individual exchanges from having fee structures that take improper advantage of the required protection against trade-throughs and undermine the overall benefits of the new private routing regime. It also would preclude an options exchange from charging excessively high fees selectively to competitors. The Commission notes that several exchanges have rules that allow—and encourage—their members to electronically “step up” and match a better-priced bid or offer available on another exchange—a “flash” functionality—rather than send orders to other exchanges for execution. 72 These exchanges stated that they implemented this “flash” functionality because of the high costs associated with routing an order to away exchanges to be executed, particularly one with a Make or Take fee model. 73 72 See, e.g., ISE Rule 803, Supplementary Material .02 and Securities Exchange Act Release Nos. 57551 (March 25, 2008), 73 FR 16917 (March 31, 2008) (SR-ISE-2008-28) and 58038 (June 26, 2008), 73 FR 38261 (July 3, 2008) (SR-ISE-2008-50). See also ISE Fee Schedule, supra note 32, at 3-4 (as an inducement to step-up and avoid routing to away markets, ISE waives the transaction fee for members when they execute against a public customer order that is exposed pursuant to ISE Rule 803, i.e., ISE's step-up mechanism) (current as of January 8, 2010). 73 See, e.g., letters from William J. Brodsky, Chairman and Chief Executive Officer, CBOE, to Elizabeth M. Murphy, Secretary, Commission, dated November 18, 2009, at 2 (comment to Flash Order Proposal) (“CBOE Flash Letter”); Michael J. Simon, Secretary, ISE, to Elizabeth Murphy, Secretary, Commission, dated November 23, 2009 at 5 (comment to Flash Order Proposal) (“ISE Flash Letter”); Tony McCormick, CEO, BOX, to Elizabeth M. Murphy, Secretary, Commission, dated November 23, 2009, at 3 (comment to Flash Order Proposal). See also Securities Exchange Act Release Nos. 57551 (March 25, 2008), 73 FR at 16917 (March 31, 2008) (SR-ISE-2008-28) and 57937 (June 6, 2008), 73 FR 33865 (June 13, 2008) (SR-CBOE-2008-58) (relating to electronic exposure on HAL). The Commission separately has proposed changes to Rule 602 of Regulation NMS that may affect these electronic “step-up” mechanisms, if adopted. 74 There are structural differences between the listed options exchanges and the cash equity markets that commenters identified as making the use of “flash” orders on the options exchanges serve a different purpose. In particular, commenters stated that eliminating the ability of market participants on the options exchanges to “step up” to better prices on other exchanges through the use of “flash” orders could impose significant costs on retail options customers whose orders would be routed to other options exchanges because, in part, of the absence of any limits on the fees options exchanges may charge to access their quotations. 75 74 See Flash Order Proposal, supra note 19. 75 See SIFMA Flash Letter, supra note 39, at 5; Ameritrade Flash Letter, supra note 39, at 3; optionsXpress Flash Letter, supra note 39, at 6; and Citadel Letter II, supra note 39, at 6 (arguing that if the Commission were to ban or limit the use of step-up mechanisms in the options markets, the need for an access fee cap would become essential). The Commission also believes that for quotations to be fair and useful, there must be some limit on the extent to which the all-in price for those who access quotations can vary from the displayed price. 76 The wider the disparity in the level of fees among the different exchanges, the less useful and accurate are the displayed prices. For example, if two options exchanges displayed quotations to sell an option for $10.00 per contract, one exchange offer could be accessible for a total price of $10.00 per contract plus a $0.50 per contract access fee, while the second exchange might not charge any such access fee. What appeared in the consolidated data stream to be identical quotations in terms of all-in costs would in fact not be identical. Access fees tend to be highest when exchanges use them to fund substantial rebates to liquidity providers, rather than merely to compensate for agency services. 77 These concerns were also expressed by several commenters who argue that for quotations to be fair and useful, there must be some limit to the extent to which the displayed price can vary from the “all-in” price 78 of a quotation. 79 If exchanges were allowed to charge exorbitant fees and pass most of them through as rebates, the published quotations of such exchanges would not reliably indicate the all-in price actually available. 76 See NMS Adopting Release, supra note 4, at 37545. 77 Id. at 37544. 78 The term “all-in” price is intended to capture the total costs for executing a trade. See infra note 90 and accompanying text. 79 See BOX Letter, supra note 37, at 5-6 (stating its agreement with Citadel and the Commission that “[f]or quotations to be fair and useful, there must be some limit on the extent to which the true prices for those who access quotations can vary from the displayed price”); Citadel Petition, supra note 34, at 3-5 (arguing that markets employing a Make or Take fee model are charging excessive fees to obtain access to their quotations and, as a result, are causing distortions in such quotations, which should otherwise reliably represent the true prices actually available to investors.); NYSE Euronext Letter, supra note 37, at 3 (stating generally that they are in favor of rules that ensure the reasonableness of fees, similar to rate caps that were enacted in the equities markets in Regulation NMS); TD Ameritrade Letter, supra note 37, at 1-2; and Wolverine Letter, supra note 37, at 6 (asserting that unrestricted fees that members would have to pay would result in executions at prices materially different from the displayed quotations and, as a consequence, run contrary to the purposes behind the trade-through rules and the principles of best execution). Section 11A(c)(1)(B) of the Exchange Act authorizes the Commission to adopt rules assuring the fairness and usefulness of quotation information. For quotations to be fair and useful, there must be some limit on the extent to which the all-in price for those who access quotations can vary from the displayed price. An access fee limit also creates more transparency in the cost of accessing quoted prices. Currently, there are so many different fees across options exchanges, across different categories of options participants, and across different product types, that it is not easy to estimate the total cost of executing against a quotation for a particular transaction. An access fee cap would provide clearer information on the maximum cost for accessing quoted prices. Consequently, the proposed fee limitation would further the statutory purposes of the Exchange Act by precluding the distortional effects of access fees. The Commission preliminarily believes that to fully support the integrity of the price protection requirement in the Trade-Through Rules and to achieve the goals that an exchange's displayed quotations be fair and useful and reliably represent the all-in prices that are actually available to investors, the proposed fee limitation should apply to any fee, no matter what it is called, 80 charged to any person 81 for the execution of an incoming order against an options exchange's best bid and offer. As discussed above, the Commission believes that the benefits of intermarket price protection and more efficient linkages could be compromised if options exchanges charge substantial fees for accessing their best bids and offers. The proposed fee limitation is designed to preclude individual exchanges from having fee structures that take improper advantage of the required protection against trade-throughs and undermine the overall benefits of the new private routing regime. It also would preclude an options exchange from charging excessively high fees selectively to competitors. In this regard, the Commission preliminarily believes that limiting the proposed fee cap to apply to only one type of fee charged (for instance, only to “Take” fees), or limiting the proposed fee cap to fees charged only to certain persons (for example, only to non-members) by an options exchange for execution against the exchange's best bid and offer would not fully achieve these objectives because it would not cover all fees that could be charged for access to the exchange's best quotation. 80 See NYSE Euronext Letter, supra note 37, at 3 (stating that access fees should be addressed not as one model versus the other, but as a fee to access the market independent of the market structure that marketplace employs). 81 See Wolverine Letter, supra note 37, at 6 (asserting that, while a proposed fee cap would reduce Take fees charged to non-members forced to access “outlier” markets at the NBBO due to trade-through obligations, members would still be forced to pay unrestricted fees) and GETCO Letter, supra note 37, at 3 (stating that if the Commission does decide to place caps on access fees charged by exchanges using the “Make or Take” fee model, it should also cap all-in access fees for traditional exchanges, regardless of the type of market participant accessing the exchange's quotation). The Commission has received comments that the Make or Take fee structure exerts competitive pressure on the “traditional” fee structure where market makers pay brokers for order flow, and that imposing a cap on Take fees would limit the ability of exchanges that employ a Make or Take model to compete effectively with other exchanges that employ a Broker Payment model, to the detriment of investors. 82 The Commission supports the development of competing market models, as long as they are consistent with the requirements of the Exchange Act. An exchange could not, however, engage in conduct that is otherwise inconsistent with the requirements of the Exchange Act, 83 even if doing so would help that exchange to compete. As discussed above, the Commission preliminarily believes that the benefits of intermarket price protection and more efficient linkages could be compromised if options exchanges charge substantial fees for accessing their best bids and offers, and that a fee limitation is necessary to support the integrity of the price protection requirement under the Trade-Through Rules, but it requests comment on this issue. 84 The Commission also believes that for quotations to be fair and useful, there must be some limit on the extent to which the all-in price for those who access quotations can vary from the displayed price. 85 The Commission preliminarily believes that adopting an access fee limit of $0.30 per contract for option exchanges, regardless of their particular market structure, would not compromise the competitive viability of exchanges employing a Make or Take fee structure because it preliminarily believes that the proposed level of fee cap would provide those exchanges with sufficient flexibility to structure their fees and rebates to support their market model. 86 Although the Commission preliminarily believes that the proposed fee limit would continue to allow for competition among the options exchanges, it requests comment on this issue and comment on other ways to achieve the Commission's objectives. 87 82 See BOX Letter, supra note 37, at 2-3; IB Letter, supra note 37, at 2-3; and GETCO Letter, supra note 37, at 3. 83 See 15 U.S.C. 78f(b) and 15 U.S.C. 78s(g). 84 See supra note 69 and accompanying text. 85 See supra note 76 and accompanying text. See also NMS Adopting Release, supra note 4, at 37545. 86 See infra Section VIII.A.2 (discussing the impacts of the proposed amendments to Rules 610(a) and (c) on competition). See also infra notes 89 and 172 and accompanying text (noting that the experience of the markets trading NMS stocks in recent years suggests that a fee cap of $0.30 per 100 shares did not prevent markets using a Make or Take fee model from competing effectively in a market where some participants engage in payment for order flow). 87 See infra Sections V (Request for Comment) and VIII.A.2 (discussing the impacts of the proposed amendments to Rules 610(a) and (c) on competition). The Commission preliminarily believes that a limitation on access fees of $0.30 per contract (equal to $0.003 per share) would be a fair and appropriate solution. In the Commission's preliminary view, limiting access fees to $0.30 per contract would promote intermarket access, standardization of quotations, and the Commission's goals for an effective and efficient linkage between and among the options exchanges. The proposed fee limitation would place all options exchanges on a level playing field in terms of the fees they can charge for the execution of incoming options orders against their best bid and offer. Some exchanges might choose to charge lower fees, thereby increasing their ranking in the preferences of order routers; others might charge the full $0.30 per-contract fee and rebate a substantial portion to liquidity providers. The Commission preliminarily believes that competition would ultimately determine which strategy is most successful. The Commission recognizes, however, that even though it is not proposing to prohibit an exchange from employing any particular market model, the proposed fee limitation may impact different market models in different ways. An exchange with a Make or Take fee model that currently charges a Take fee in excess of the proposed fee cap would take in less revenue per contract from a reduced Take fee, while an exchange with a Broker Payment fee model that charges a transaction fee in excess of the proposed fee cap would take in less revenue per contract from a reduced transaction fee. These reduced fees for accessing an exchange's best bid or offer, standing alone, might have an impact on the manner in which broker-dealers and other market participants, including the exchanges, route order flow. The exchange with the Make or Take fee model, however, might choose to recoup some of that revenue by reducing its Make rebate, which may have an impact on the quoting behavior of market participants that provide liquidity on that exchange. An exchange with a Broker Payment model might choose to recoup some of the revenue by amending other fees charged to its members, which might impact the order routing or other behavior of those members (and the members' customers), depending upon the type of fee change. Accordingly, although the Commission preliminarily believes that the proposed fee limit would allow for vigorous competition among the options exchanges, it requests comment on the impact of the proposed fee limit on the different exchanges' and market participants' behavior. 88 88 See infra Sections V (Request for Comment) and VIII.A.2 (discussing the impacts of the proposed amendments to Rules 610(a) and (c) on competition). The Commission is proposing to set a flat fee cap of $0.30 per contract (the equivalent of $0.003 per share). The Commission is not proposing to establish a cap for low-priced options based on a percentage of the options' price, similar to the existing fee cap of 0.3 percent of the quotation price per share for NMS stocks. The Commission's proposal is based on its preliminary view that the $0.30 per-contract level is consistent with the maximum fee limit for NMS stocks under Rule 610(c). The experience of the markets trading NMS stocks in recent years suggests that a fee cap of $0.30 per 100 shares did not prevent markets using a Make or Take fee model from competing effectively in a market where some participants engage in payment for order flow. 89 In addition, this access fee cap level would help ensure that the “all-in” fee 90 would be below the $1 minimum quoting increment 91 so that the quotations displayed in the NBBO indicate the best prices. For example, having a $0.30 cap 92 would help ensure that an offer of $2 is not inferior to an offer of $2.01 once access and other per-contract fees were added to the price. Stated another way, the Commission preliminarily believes that setting the proposed fee cap at $0.30 per contract would allow options exchanges flexibility to generate revenues from access fees while still providing the exchange the ability to continue to charge other fees, such as “licensing” fees charged by exchanges for executions in certain index options 93 or routing fees, 94 without exceeding the $1 minimum increment. 89 See infra note 172 and accompanying text. 90 The “all in” fee for transactions in options contracts may include multiple charges such as “Take” fees or transaction fees, routing fees, and licensing fees. See supra note 78. 91 Since every options quotation represents a cost equal to 100 times its price, a penny increment—the smallest possible increment for certain options—equals $1.00 in option cost. 92 A $0.30 per-contract access fee is equal to a fee of $0.003 per underlying share. 93 These “licensing” fees generally do not exceed $0.22 per contract. See, e.g., CBOE Fee Schedule (available at http://www.cboe.com/publish/feeschedule/CBOEFeeSchedule.pdf ) (current as of February 2, 2010); and NYSE Arca Fee Schedule (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010). 94 Fees charged by options exchanges for routing orders to execute on other exchanges range from $0.00 to $0.95 per contract. See NYSE Arca Fee Schedule (available at http://www.nyse.com/pdfs/NYSE_Arca_Options_Fee_Schedule1-08-2010.pdf ) (current as of January 8, 2010); and CBOE Fee Schedule (available at http://www.cboe.com/publish/feeschedule/CBOEFeeSchedule.pdf ) (current as of March 16, 2010) (CBOE charges a $0.50 per contract fee for routing non-customer orders in addition to the customary CBOE execution charge, which for electronic orders for broker-dealers is $0.45 per contract). The Commission preliminarily believes that a flat $0.30 per-contract fee cap for all options would strike the appropriate balance between imposing a cap to carry out the objectives discussed above and providing options exchanges flexibility to compete with one another. 95 The Commission preliminarily does not believe that a cap for low-priced options should be based on a percentage of the quotation price as it is for low-priced NMS stocks. The Commission preliminarily believes that differences in the markets for NMS stocks and listed options merit this distinction. First, if an NMS stock is trading at a very low price, the access fee can become significant as a percentage of the total economic exposure. This result is less likely for listed options, given the leverage implicit in an option contract. For example, if an NMS stock is trading for $0.01 per share, so that an order for 100 shares represents $1 worth of stock, an access fee of $0.30 for 100 shares would represent thirty percent of the total economic position. On the other hand, an NMS stock priced at $10 per share could have a short-term out-of-the-money option priced at $0.01. If the Delta 96 of this option is 0.05, then one option contract would cost $1 but would give the investor exposure equivalent to an investment of $50 of the stock. An access fee of $0.30 per contract for the option would represent only six-tenths of one percent of the economic position. 97 95 See infra Section VII.B.2 (discussing generally the costs and benefits of the proposal) and notes 179-183 and accompanying text (discussing the costs with respect to options exchanges that would need to amend their rules to comply with the access fee limitation as a result of proposed Rule 610(c)(2)). 96 Delta is measured as the change in the option price divided by the change in the underlying asset price. See Guy Cohen, Options Made Easy (2d ed., Upper Saddle River: FT Prentice Hall 2005). 97 A $0.30 per-contract access fee would be a more significant percentage of the option price as the option price decreases. For example, for an option priced at $0.01, a $0.30 per-contract access fee would be 30% of the total option price ($0.01 × 100 = $1 per contract, and $0.30 is 30% of $1). The Commission preliminarily believes, however, that a flat cap of $0.30, rather than a cap based on a percentage of the option price for low-priced options, strikes the appropriate balance, for the reasons discussed in this section. The Commission, however, requests comment on the issue. See infra Section V (Request for Comment). Second, the restriction on subpenny quoting in NMS stocks does not apply to stocks priced below $1. 98 Thus, for certain low-priced NMS stocks, an access fee of $0.003 per share could be larger than the minimum quoting increment, making it possible for an order to be routed to an exchange quoting a better price but ending up with an inferior all-in price after the access fee. For NMS stocks, the percentage fee cap for stocks priced below $1 helps to mitigate this concern. Because listed options are not currently quoted in subpenny increments, these concerns are not present, and, therefore, the Commission preliminarily believes it is unnecessary to establish a cap based on a percentage of the options' price for low-priced options. Further, if the Commission were to propose a percent-based fee cap for low-priced options, the access fee cap would be, in some cases, less than the amount of the “licensing” fees charged by exchanges for executions in certain index options. 98 See Rule 612 of Regulation NMS, 17 CFR 242.612. Finally, a significant percentage of options contract trading volume is in lower priced options. 99 Thus, the Commission estimates that imposing a flat $0.30 per-contract cap, and not including a percentage fee cap for low-priced options similar to the existing fee cap of 0.3 percent of the quotation price per share for NMS stocks, would result in less potential revenue loss for options exchanges from the impact of the proposed fee cap and, therefore, possibly reduce the need for the options exchange to impose other fees on market participants. 100 99 Approximately 76% of the contract volume is in options priced at $3 or below, and approximately 48% of the contract volume is in options priced at $1 or below (these estimates are based on December 2009 volume data from OptionsMetrics). 100 See infra notes 179-187 and accompanying text for a discussion of the estimated costs of the proposed fee cap on options exchanges. B. Terms of Proposed Rule 610(c)(2) Under proposed Rule 610(c)(2), a national securities exchange would be prohibited from imposing, or permitting to be imposed, any fee or fees that exceeds or accumulates to more than $0.30 per contract for the execution of an order against any quotation in an option series that is the best bid or best offer of such national securities exchange. Thus, when triggered, the proposed fee limitation would apply to any order execution at the displayed price of the best bid or offer and would therefore encompass executions of orders against both the displayed size and any reserve size at the price of those quotations. Further, proposed Rule 610(c)(2) would apply to any fee based on the execution of an incoming order against an exchange's best bid or offer, such as a “Take” fee or other “transaction” fee charged by the exchange when an incoming order executes against the best bid or offer of the exchange. The Commission preliminarily believes that the proposed fee limitation would apply to other types of fees charged by an exchange to a member who represents an incoming order that trades against the exchange's best bid or offer. For example, the proposed fee limitation would apply to fees charged by various exchanges for the execution of orders in certain options on indexes (called “licensing” or “index surcharge” or “royalty” fees) when the fee is charged for the execution of an incoming order against the exchange's best bid or offer. The proposed fee limitation also would apply to options regulatory fees (“ORF”), such as those that have been adopted by several exchanges. 101 For those exchanges that have adopted an ORF, the fee is charged on a per-contract basis and is assessed on each member for all options transactions executed or cleared by the member in a customer account. Because an ORF would constitute a fee for accessing the best bid or offer of an options exchange when such fee is assessed on a customer order that trades with the exchange's best bid or offer, the ORF would be covered by the proposed amendments to Rule 610(c)(2). So long as the fees are based on the execution of orders against the best bid or offer of the exchange, the proposed restriction in Rule 610(c)(2) would apply. Conversely, fees not triggered by the execution of orders against such quotations ( e.g., certain periodic fees such as monthly or annual fees) would not be included. 101 See Securities Exchange Act Release Nos. 58817 (October 20, 2008), 73 FR 63744 (October 27, 2008) (SR-CBOE-2008-105); 61133 (December 9, 2009), 74 FR 66715 (December 16, 2009) (SR-Phlx-2009-100); 61154 (December 11, 2009), 74 FR 67278 (December 18, 2009) (SR-ISE-2009-105); and 61388 (January 20, 2010), 75 FR 4431 (January 27, 2010) (SR-BX-2010-001). The proposed fee limitation in Rule 610(c)(2) would apply to any fee charged directly by an options exchange. It would also limit any fee charged by a market participant, such as a market maker, that displays a quotation through the exchange's facilities. The Commission, however, understands that market participants in the options markets currently do not charge access fees. Nothing in proposed Rule 610(c)(2) would preclude an options exchange from taking action to limit fees beyond what would be required under the proposed rule, and such exchange would have flexibility in establishing its respective fee schedule to comply with proposed Rule 610(c)(2). The proposed access fee limitation in Rule 610(c)(2) would apply only to quotations that market participants are required to access to comply with the Trade-Through Rules; it would not apply to depth of book quotations. By proposing to apply the fee cap only to the best bid or offer of an options exchange, the limitation is designed to have minimal impact on competition and individual business models while furthering the objectives of the Exchange Act by preserving the fairness and usefulness of quotations, and by providing support for the proper functioning of the Trade-Through Rules, as discussed above. 102 102 See NMS Adopting Release, supra note 4, at 37546. Further, as the Commission noted in adopting current Rule 610(c), a market participant could intend to interact only with a quotation subject to the access fee cap in Rule 610(c) but in fact execute against a quotation not subject to the cap. For example, at the time a market participant routes an order to an exchange, it could be attempting to execute only against that exchange's best bid or offer, which would be subject to the proposed fee cap. By the time the order arrives at the exchange, the incoming order may, if a better priced bid or offer has been displayed at the exchange for a size smaller than the size of the incoming order, execute partially against the new best bid or offer and partially against the quotation that was previously the exchange's best bid or offer. If the exchange were to charge a fee higher than the access fee cap to the market participant accessing the previous best bid or offer, the Commission believes that such charge could undermine the purpose of the proposed access fee cap as discussed above. Therefore, the Commission believes that to meet the requirements of proposed Rule 610(c)(2), an exchange would have to ensure that it never charges a fee in excess of the cap when a market participant tries to access only the exchange's best bid or offer. 103 103 This is consistent with the approach in Regulation NMS. Id. The operation of this limitation would be based on quotations as they are displayed in the consolidated quotation stream. Thus, the exchange would be responsible for ensuring that any time lag between prices in its internal systems and its quotations in the consolidated quotation system do not cause fees to be charged that would violate the limitation of proposed Rule 610(c)(2). Compliance with this requirement obviously would not be a problem for exchanges that do not charge any fees in excess of the proposed cap. If an exchange were to choose to charge higher fees for access to its depth of book quotations, 104 the Commission does not believe the exchange could comply with the proposed Rule 610(c)(2) unless it provided a functionality that enables market participants to assure that they will never inadvertently be charged a fee in excess of the cap. For example, such an exchange could provide a “top-of-book only” or “limited-fee only” order functionality. By using this functionality, market participants themselves could assure that they were never required to pay a fee in excess of the levels proposed in Rule 610(c)(2). 105 Further, for similar reasons, the proposed access fee limitation in Rule 610(c)(2) would apply to an exchange's non-displayed quotations in listed options that are priced better than the exchange's displayed best bid or offer. Specifically, if an exchange had an order type that allowed an order to be entered at a price that is not displayed but is available for execution, the proposed fee limitation would apply to an execution against that non-displayed price. 106 104 The Commission is not aware of any options exchange that charges differential fees for accessing depth-of-book quotations, but requests comment on the issue. 105 The existing access fee cap for NMS stocks operates in this same manner. See id. 106 See, e.g., Chapter VI, Sections 6 and 7 of the NOM Rules governing NOM's price improving order type. “Price Improving Orders” are defined under the NOM Rules as orders to buy or sell an option at a specified price at an increment smaller than the minimum price variation in the security. Price Improving Orders may be entered in increments as small as one cent, and those Price Improving Orders that are available for display must be displayed at the minimum price variation in that security and rounded up for sell orders and rounded down for buy orders. See Chapter VI, Section 1(e)(6) of the NOM Rules (defining Price Improving Orders). C. Payment for Order Flow In a traditional payment for order flow arrangement in the options market, a specialist or market maker offers cash and non-cash inducements to brokers that direct orders to the specialist or market maker. The specialist or market maker is willing to pay firms for this order flow because it knows that it will be able to trade with a portion of such orders due to specialist and market maker guarantees provided by the exchanges. 107 In addition, some exchanges have adopted fees on market makers to facilitate their members' payment for order flow. 108 Typically, the exchange charges each market maker a fee for trading with customer orders on the exchange. The exchange then pools the proceeds from such fees and allows specialists and/or market makers to use such funds to pay for order flow. 109 107 See, e.g., CBOE Rule 8.13 and ISE Rule 713. 108 See, e.g., Securities Exchange Release Nos. 48053 (June 17, 2003), 68 FR 37880 (June 25, 2003) (SR-Amex-2003-50) (immediately effective proposed rule change to reinstate marketing fee to raise revenue for Amex specialists to compete for order flow); 47948 (May 30, 2003), 68 FR 33749 (June 5, 2003) (SR-CBOE-2003-19) (immediately effective proposed rule change to reinstate marketing fee to compete for order flow); 47090 (December 23, 2002), 68 FR 141 (January 2, 2003) (SR-Phlx-2002-75) (immediately effective proposed rule change to reinstate marketing fee to compete for order flow); 43833 (January 10, 2001), 66 FR 7822 (January 25, 2001) (SR-ISE-00-10) (order approving ISE's payment for order flow program); 43290 (September 13, 2000), 65 FR 57213 (September 21, 2000) (SR-PCX-00-30) (immediately effective proposed rule change to adopt a payment for order flow fee); 43228 (August 30, 2000), 65 FR 54330 (September 7, 2000) (SR-Amex-00-38) (immediately effective proposed rule change to establish new marketing fee to raise revenue for Amex specialists to compete for order flow); 43177 (August 18, 2000), 65 FR 51889 (August 25, 2000) (SR-Phlx-00-77) (immediately effective proposed rule change to adopt a payment for order flow fee); and 43112 (August 3, 2000), 65 FR 49040 (August 10, 2000) (SR-CBOE-00-28) (immediately effective proposed rule change to establish new CBOE marketing fee to raise revenue that could be used by CBOE market makers to pay for order flow). 109 For example, NYSE Amex LLC (“NYSE Amex”) imposes a $0.65 per-contract marketing fee for non-Minimum Quoting Increment Pilot Program classes and a $0.25 per-contract marketing fee for Minimum Quoting Increment Pilot Program classes where a market maker trades against an incoming electronic customer order. See NYSE Amex Options Fee Schedule (available at http://www.nyse.com/pdfs/NYSE_Amex_Options_Fee_Schedule01.04.10.pdf ) (current as of January 4, 2010). Several commenters argue that, if the Commission were to limit “Take” fees, it also should limit fees associated with payment for order flow arrangements. 110 This view is premised on the notion set forth by several commenters that payment for order flow fees affect quoted prices, and thus executions received by investors, because market makers that have to pay for order flow will reflect that cost in their quoted prices. 111 In this regard, one commenter petitioned the Commission to impose a cap at the same level on private payment for order flow arrangements between market makers and agency brokerage firms as any cap it imposes on “Take” fees. 112 Another commenter argues that fees relating to “accessing” quotations can be characterized broadly to include exchange fees used to fund members' payment for order flow. 113 110 See BOX Letter, supra note 37, at 2 (stating its belief that, if the Commission does decide to enact fee caps, a cap on Take fees is acceptable only to the extent that other options exchanges are willing to accept a comparable limit on payments and fees associated with exchange payment for order flow) and Wolverine Letter, supra note 37, at 7 (stating that any cap on make-take fees should be made in conjunction with a commensurate cap on payment for order flow fees). 111 See BOX Letter, supra note 37, at 4; GETCO Letter, supra note 37, at 3-6; IB Letter, supra note 37, at 2-3 and 6-7; and Wolverine Letter, supra note 37, at 4. 112 See IB Letter, supra note 37, at 1 and 6. 113 See Wolverine Letter, supra note 37, at 3. The Commission agrees with commenters that payment for order flow fees, among other costs, affect quoted prices. However, the Commission is not proposing to specifically limit payment for order flow, nor the exchange fees imposed on market makers to fund members' payment for order flow. Instead, the Commission is proposing to limit the amount of fees that an exchange can impose, or permit to be imposed, for access to the best bid and offer of the exchange. The Commission preliminarily does not believe that an exchange payment for order flow fee on members is an access fee, i.e., it is not a fee imposed for executing against an exchange's quotation. The basis for the proposal, as discussed at length above, 114 is to (1) provide for fair and efficient access to displayed quotations to support the integrity of the price protection requirement contained in the Trade-Through Rules, and (2) further the objective that quotations be fair and useful by limiting the extent to which the all-in price can vary from the displayed price. 114 See supra notes 58-100 and accompanying text. The Commission preliminarily believes these objectives can be achieved without limiting payment for order flow fees. Payment for order flow is when a market maker offers cash and non-cash inducements to brokers that direct orders to the market maker. In addition, some exchanges impose a fee on market makers to facilitate their members' payment for order flow. 115 Payment for order flow fees are not fees imposed by an exchange on incoming orders for executing against an exchange's quotations. Therefore, the Commission preliminarily does not believe that payment for order flow fees directly impact the ability of a market participant to access an exchange's best priced displayed quotations, and therefore does not believe that limiting payment for order flow fees is necessary to achieve the objectives of the proposed fee cap—to provide for fair and efficient access to displayed quotations and that displayed quotations be fair and useful. 115 See supra notes 107-109 and accompanying text. However, if a market maker is charged a payment for order flow fee by an exchange when the market maker is accessing the best bid or offer of the exchange, then the proposed fee limitation would apply to that fee because it would be a fee for the execution of an order against the best bid or offer of the exchange. A payment for order flow fee would be a fee for accessing an exchange's best bid or offer if, for example, a market maker's quote traded against a resting customer limit order that is the best bid or offer of the exchange. Similarly, a payment for order flow fee would be a fee for accessing an exchange's best bid or offer if a market maker sent an order in a class to which it is not appointed as a market maker, and that order trades against a customer order resting on the exchange's limit order book that is the best bid or offer of the exchange. In sum, if the rules of the exchange provide that the market maker would pay a payment for order flow fee for executing against the resting customer order that is the best bid or best offer of the exchange, that fee would be covered by proposed Rule 610(c)(2). On several occasions, the Commission has recognized that the anticipation of payment for order flow raises a potential conflict of interest for brokers handling customer orders, and that reliance by market centers on the strategy of simply paying money to attract orders may present a threat to aggressive quotation competition. 116 At the same time, the Commission has stated that payment for order flow is not necessarily inconsistent with a broker's duty of best execution, so long as appropriate measures are taken to ensure that that duty is, in fact, met. 117 The Commission further acknowledges the broader concern that payment for order flow may result in less aggressive competition for order flow on the basis of price, 118 such as through displaying aggressively-priced quotations or offering opportunities for price improvement. However, the Commission has stated that singling out and banning only one particular form of such payment—for example, payment made possible by an exchange through the collection of fees from its market makers—would scarcely address the issue on the larger scale. 119 116 See, e.g., Options Concept Release, supra note 21, at 6128-6130. 117 See Securities Exchange Act Release No. 43833 (January 10, 2001), 66 FR 7822 (January 25, 2001) (SR-ISE-00-10) (citing to Securities Exchange Act Release No. 42450 (February 23, 2000), 65 FR 10577 (February 28, 2000)); see also Options Concept Release, supra note 21, at 6128-6129. 118 See Securities Exchange Act Release No. 43833, supra note 117, at 7825. 119 Id. Further, as noted above, the Commission believes that market forces and the dynamics of competition should determine exchange fees, to the extent practicable. 120 Payment for order flow fees generally are charged by exchanges to market makers when they execute against a customer order. If a market maker does not want to pay this fee, the market maker is free to give up its appointment as a market maker on that exchange and become a liquidity provider on another exchange with a more attractive fee structure. For instance, an exchange may set a fee to collect funds for members' payment for order flow at such a level that a market maker may determine it can no longer effectively compete for order flow based on its quotations, which must incorporate the costs of all fees. 121 The market maker may then make the determination to become a liquidity provider on another exchange where it is able to compete more effectively based on the price of its quotations. Similarly, an exchange may determine to charge any market participant a fee for providing liquidity on its exchange. 122 If a market participant did not want to pay this fee, it could choose to send its non-marketable limit order to another options exchange with a more attractive fee structure. The Commission therefore preliminarily believes that competition among the various options exchanges, and the different market models, will act to restrict payment for order flow and other fees for providing liquidity. 123 120 See supra note 58. 121 This would assume that the amount of the payment for order flow fee impacts the price at which the market maker is willing to quote. 122 See, e.g., BOX Fee Schedule, Section 7 (available at http://www.bostonoptions.com/pdf/BOX_Fee_Schedule.pdf ) (current as of January 2010) (imposing a $0.55 fee for adding liquidity in Non-Penny Classes, a $0.15 fee for adding liquidity in Penny Pilot Classes except SPY, QQQQ, and IWM, and a $0.05 fee for adding liquidity in SPY, QQQQ, and IWM). In its filing imposing this fee, BOX stated that the changes proposed are in response to various “Payment for Order Flow” programs currently in operation on other options exchanges. See Securities Exchange Act Release No. 60934 (November 4, 2009), 74 FR 58358 (November 12, 2009). 123 The Commission also notes that the exchanges generally lowered the level of payment for order flow fees charged to their market makers in classes included in the Minimum Quoting Increment Pilot Program. See Securities Exchange Act Release Nos. Securities Exchange Act Release Nos. 55328 (February 21, 2007), 72 FR 9050 (February 28, 2007) (SR-Amex-2007-16); 55265 (February 9, 2007), 72 FR 7697 (February 16, 2007) (SR-CBOE-2007-11); 55271 (February 12, 2007), 72 FR 7699 (February 16, 2007) (SR-ISE-2007-08); 55223 (February 1, 2007) 72 FR 6306 (February 9, 2007) (SR- NYSEArca-2007-07); and 55290 (February 13, 2007), 72 FR 8051 (February 22, 2007) (SR-Phlx-2007-05). As noted above, currently approximately 69.5 percent of trading volume is in classes included in the Minimum Quoting Increment Pilot Program where trading interest can be represented in the quote in one-cent increments, and by August 2, 2010, 363 classes will be included in the Minimum Quoting Increment Pilot Program, representing approximately 88.1 percent of trading volume during February 2010. See supra note 29 and accompanying text. IV. Technical Amendments to Rule 610 The Commission is proposing to amend Rule 610(c) to reflect that Nasdaq is now registered as a national securities exchange under Section 6(a) of the Exchange Act. 124 The current rule's prohibition on a trading center imposing, or permitting to be imposed, fees in excess of the stated limits applies to the execution of an order against a protected quotation of the trading center or against any other quotation of the trading center that is “the best bid or best offer of a national securities exchange, the best bid or best offer of The Nasdaq Stock Market, Inc., or the best bid or best offer of a national securities association other than the best bid or best offer of The Nasdaq Stock Market, Inc. in an NMS stock.” Given Nasdaq's current status as a registered national securities exchange, there no longer is a need to separately reference Nasdaq's best bid or best offer. Therefore, the Commission is proposing to amend Rule 610(c)(1) to simplify the relevant language to refer only to any other quotation of the trading center that is the best bid or best offer of a national securities exchange or the best bid or best offer of a national securities association in an NMS stock. 125 124 See 15 U.S.C. 78f(a); see also Securities Exchange Act Release No. 53128 (January 13, 2006), 71 FR 3550 (January 23, 2006). 125 See proposed Rule 610(c)(1). The Commission also is proposing to make technical changes to Rule 610(c) to reflect the addition of proposed Rule 610(c)(2) that would apply to listed options. V. Request for Comments The Commission requests the views of commenters on all aspects of this proposal, including whether the proposal is consistent with the provisions of the Exchange Act. In particular, the Commission requests comment on the following: 1. Rule 610(a) currently prohibits the imposition of unfairly discriminatory terms that prevent or inhibit any person from obtaining efficient access through a member of the exchange to quotations in NMS stocks. The Commission requests comment on its proposal to extend this prohibition to include access to quotations of listed options. The Commission further requests comment on whether the Commission's rules also should prohibit unfairly discriminatory terms for other services offered by exchanges. For example, should the Commission rule be expanded to cover exchange transaction fees generally, even those transaction fees that are not based on accessing the exchange's quotations? 2. Rule 610(a) as proposed to be amended would prohibit an exchange from charging higher “Take” fees in certain options classes to non-directed customers than to directed customers. Do commenters agree that such a fee differential should be prohibited by the proposed amendments to Rule 610(a)? 3. As discussed above, the Commission is proposing to limit fees charged for accessing the best bid and offer in a listed option, as proposed in Rule 610(c)(2), to support fair and efficient access to an exchange's quotations, and to provide greater transparency in the quoted price. To what extent is this action necessary to achieve these objectives? To what extent do competitive forces in the options markets currently act, or will continue to act, to keep fees such as access fees at a level that does not impede fair and efficient access to an exchange's quotations, or impede the transparency of the quoted price? Does the existence of flash functionality at some of the exchanges that trade listed options have an impact on the level at which options exchanges set access fees? 126 126 The Commission separately has proposed changes to Rule 602 of Regulation NMS that, if adopted, would affect flash functionality in the listed options markets, raising concerns about access to order information and incentives for market participants to display their trading interest publicly. See Flash Order Proposal, supra note 19, and supra notes 72-75 and accompanying text. 4. The markets for trading NMS stocks are similar in certain ways to the markets for trading listed options, and in other ways are different. The Commission requests comment on whether, and how, those similarities and differences should impact a decision to apply an access fee cap, as proposed, in the options markets. For example, both NMS stocks and listed options can be traded on multiple markets, and broker-dealers that trade NMS stock and listed options have a duty of best execution with respect to each. Likewise, both markets have prohibitions on trading-through. How, if at all, do these similarities support, or not, the proposed fee cap for accessing an options exchange's best bid and offer? Unlike NMS stocks, listed options are only traded on exchanges, and not in the over-the-counter (“OTC”) market. It can be argued that one result of the lack of OTC trading in listed options is that more “good” order flow (that is, order flow relatively uninformed about future prices) reaches the options exchanges than the exchanges that trade NMS stocks. 127 It can be further argued that because quotations must be available for execution to all incoming order flow—both informed and uninformed—the quotations must be wider than the prices that could be offered exclusively to uninformed order flow. 128 In addition, it is argued that investors in listed options depend upon the liquidity supplied by professional liquidity providers to a greater extent than in the market for NMS stocks. 129 Further, some market participants state that liquidity providers price options differently than liquidity providers price NMS stocks, pursuant to pricing models or algorithms rather than based on the inherent value of the issuer. 130 Do commenters agree with these statements? How, if at all, do these differences mitigate for or against applying the proposed fee cap for accessing an options exchange's best bid and offer? Do these differences impact the incentives for liquidity providers to quote aggressively, or the competitiveness of an options exchange's fees, differently than a market participant or market trading NMS stocks? 127 See ISE Flash Letter, supra note 73, Appendix B at 2. 128 See Letter from Larry Harris, Professor of Finance and Business Economics, USC Marshall School of Business, dated December 4, 2009 (“Harris Letter”) at 4. Prices that could be offered exclusively to uninformed order flow could incorporate tighter spreads because the market maker does not need to protect itself from adverse selection by informed traders by building in a wider spread. 129 See CBOE Flash Letter, supra note 73, at 1 and 10; ISE Flash Letter, supra note 73, at 9. See also Letter from Peter Bottini, EVP Trading and Customer Service, and Hillary Victor, Associate General Counsel, optionsXpress, Inc. (“optionsXpress”) dated November 25, 2009 (“optionsXpress Letter”) at 3. 130 See ISE Flash Letter, supra note 73, at 7-8. 5. The Commission requests comment on the different sources of revenue available to options exchanges, and any differences between those sources available to options exchanges and exchanges that trade NMS stocks. For example, exchanges that have in place rules for listing NMS stocks have the ability to charge listing fees to issuers for listing on their market. Does the amount of revenue received from market data differ significantly for options exchanges versus exchanges that trade NMS stocks? How, if at all, should any differences in sources of revenue for options exchanges versus exchanges that trade NMS stocks mitigate for or against applying the proposed fee cap for accessing an options exchange's best bid and offer? How, if at all, should any differences in sources of revenue for options exchanges versus exchanges that trade NMS stocks impact a determination as to the level of an access fee cap to be imposed? 6. If commenters do not believe that the Commission should limit fees charged for accessing the best bid and offer in a listed option, as proposed in Rule 610(c)(2), do commenters believe that the Commission should take any action with respect to fees charged, or permitted to be charged, by an options exchange for executing against the exchange's best bid or offer in a listed option? If not, please explain why not. If so, please explain why, and what alternative action the Commission should take. For example, would commenters support action by the Commission to cap all fees for executing an options order, including access fees, routing fees, and any other per contract fee, at the minimum pricing variation for the option? Would this alternative achieve the objectives of the proposed fee cap, as discussed above in Section III? Would this alternative approach provide more or less flexibility to exchanges than an access fee cap as proposed in Rule 610(c)(2)? 7. The Commission is proposing a flat fee cap of $0.30 per contract. As discussed above, the Commission's proposal is based on several factors. First, the $0.30 per-contract level is consistent with the maximum fee limit for NMS stocks under Rule 610(c). Experience of the markets trading NMS stocks in recent years suggests that a fee cap of $0.30 per 100 shares did not prevent markets using a Make or Take fee model from competing effectively in a market where some participants engage in payment for order flow. 131 In addition, this access fee cap level would help ensure that the “all-in” fee would be below the $1 minimum quoting increment. Further, the Commission preliminarily believes that setting the proposed fee cap at $0.30 per contract would allow options exchanges flexibility to generate revenues from access fees while still providing the exchange the ability to continue to charge other fees, such as “licensing” fees charged by exchanges for executions in certain index options or routing fees, without exceeding the $1 minimum increment. The Commission requests comment on this analysis. If commenters agree with this approach and threshold, please explain why; if commenters do not agree, please explain why not. 131 See infra note 172 and accompanying text. 8. If a commenter believes that a fee cap for accessing the best priced quotation in listed options is necessary and appropriate, the Commission requests comment as to what level such a cap should be set, and what considerations should be part of any analysis as to the level of a fee cap. One commenter states that while 30% of the minimum quoting increment is a reasonable access fee cap for the equity markets, which allow internalization as a defense to excessive access fees, a lower cap is needed in the options markets because internalization is not permitted, and suggests a cap of $0.20 per contract. 132 Other commenters argue that any fee cap should not be lower than $0.99 per contract (for options quoted in one-cent increments) because a customer is still better off paying a $0.99 per contract fee to execute against a price that is better by $1.00 per contract. 133 The Commission requests commenters' views on each of these alternative levels, and the reasoning supporting them. 132 See Citadel Petition, supra note 34, at 10. 133 See BOX Letter, supra note 37, at 5 (stating in part that if the Commission were to impose a fee limit that it should be $0.01 per contract less than the standard trading increment of the class); and IB Letter, supra note 37, at 4-5 (opposing any fee cap less than $0.99 per contract for a contract quoted in pennies). 9. One of the bases for the proposed access fee cap is to support the requirements of the Trade-Through Rules and the duty of best execution. It could be argued that because investors will not be worse off accessing a price that is better by $1 per contract as long as the fee to access that quotation is not more than $0.99 per contract, 134 any fee cap should not be lower than $0.99 per contract to support the operation of the Trade-Through Rules. Do commenters agree with this view? Should the fact that there is no guarantee that an order sent to another exchange to access a better displayed price will actually obtain an execution on the away exchange impact the level at which an access fee is capped? Should there be the possibility for more than a one-cent per contract advantage (which is what would result with an access fee of $0.99 per contract) to require market participants to attempt to access quotations in listed options on other exchanges that are better priced by $1 per contract? What percent of the time do orders sent to another exchange to access a better displayed price actually obtain an execution on the away exchange? What other considerations, if any, should the Commission take into account when determining the level of any fee cap imposed for access to an exchange's best bid or offer in a listed option? 134 Id. 10. As discussed above in Question 4, the markets for trading NMS stocks are similar in certain ways to the markets for trading listed options, and in other ways are different. The Commission requests comment on whether, and how, those similarities and differences should impact the level at which an access fee cap should be set for access to an options exchange's best bid and offer. Should any limit on access fees that can be imposed by the options exchanges be different than or the same as the existing limit on access fees in the market for NMS stocks? If different, please explain whether an access fee limit in the options exchanges should be higher or lower than the limit for NMS stocks, and the basis for the difference. If the same, please explain why, with specificity. 11. As discussed above, the Commission has proposed a flat access fee cap of $0.30 per contract, and not proposed a percentage fee limit for low-priced options, similar to the 0.3 percent of the price per share limit for NMS stocks priced under $1. 135 The Commission preliminarily believes that differences in the markets for NMS stocks and listed options merit this distinction. Specifically, when an NMS stock is trading at a very low price, the access fee can become significant as a percentage of the total economic exposure. This result is less likely for listed options, given the leverage implicit in an option contract. 136 In addition, the restriction on subpenny quoting in NMS stocks does not apply to stocks priced below $1. Thus, for certain low-priced NMS stocks, an access fee of $0.003 per share could be larger than the minimum quoting increment, making it possible for an order to be routed to an exchange quoting a better price but ending up with an inferior all-in price after the access fee. For NMS stocks, the percentage fee cap for stocks priced below $1 helps to mitigate this concern. Because listed options are not currently quoted in subpenny increments, these concerns are not present, and, therefore, the Commission preliminarily believes it is unnecessary to establish a cap based on a percentage of the options' price for low-priced options. 137 135 See supra notes 96-100 and accompanying text. 136 For example, if an NMS stock is trading for $0.01 per share, so that an order for 100 shares represents $1 worth of stock, an access fee of $0.30 for 100 shares would represent thirty percent of the total economic position. On the other hand, an NMS stock priced at $10 per share could have a short-term out-of-the-money option priced at $0.01. If the Delta of this option is 0.05, then one option contract would cost $1 but would give the investor exposure equivalent to an investment of $50 of the stock. An access fee of $0.30 per contract for the option would only represent six-tenths of one percent of the economic position. 137 Commission staff also estimates that imposing a flat $0.30 per-contract cap, and not including a percentage fee cap for low-priced options similar to the existing fee cap of 0.3 percent of the quotation price per share for NMS stocks, would result in less potential revenue loss for options exchanges from the impact of the proposed fee cap. See supra notes 99-100 and accompanying text. The Commission requests comment on its analysis, and whether the proposed access fee limit should have a percentage fee limit for low-priced options, similar to the 0.3 percent of the price per share for NMS stocks priced under $1, and on its reasoning for not proposing such a percent-based limit for low-priced options. If commenters believe that the proposed access fee cap should be different for low-priced options, please explain with specificity why, and what the breakpoint should be, and why. 12. As discussed above, one of the bases for the proposed fee cap is to ensure the fairness and usefulness of displayed quotations, and to enhance transparency of displayed quotations. The Commission requests comment as to whether there is a need to promote transparency of the displayed quotations in listed options beyond the status quo. 13. If commenters believe that, to support the transparency of displayed quotations, there should be a limit as to how far away from the quoted price the amount that the investor would pay (for a buy) or receive (for a sell) inclusive of access fees should be, what factors should go into determining the allowable deviation? For example, should access fees be limited to one increment less than the minimum quoting increment (for example, $0.99 per contract in an option that has a one-cent minimum increment), such that the investor would always get a better execution price net of access fees when the quoted price is better by one minimum quoting increment? Should the access fees be limited to less than half of the minimum quoting increment (for example, $0.50 per contract in an option that has a one-cent minimum increment), so that the net price to investors inclusive of access fees is closer to the displayed price than the next worse price? Should the allowable access fees be some other amount? 14. The Commission requests comment on whether there are alternative methods other than the proposed access fee cap to achieve the objective of greater transparency in displayed quotations of listed options. 15. The Commission requests comment on the types of fees that should be covered by an access fee limitation. For example, the Commission believes that proposed Rule 610(c)(2) would apply to fees charged for the execution of options on certain indexes (so-called “licensing fees,” “royalty fees,” or “index surcharge fees”). Please state why it would be appropriate or not appropriate to apply the proposed fee limitation to licensing fees. What would be the impact on these fees if the proposed fee limitation did apply? What would be the impact on market quality if the proposed fee limitation applied to licensing fees? 16. The Commission requests comment on its preliminary view of the applicability of the proposal to an ORF. 138 The Commission also requests comment on any potential impact of the proposal on an ORF. 138 See supra note 101 and accompanying text. 17. As proposed, the fee limitation in Rule 610(c)(2) would apply to fees charged for executions of orders in all listed options, including those that are listed and traded only on one options exchange (“non-multiply listed options”). Do commenters agree that Rule 610(c)(2) should apply to trades in such options? Or should any fee cap apply only to multiply listed options? Or should the proposed fee limitation in Rule 610(c)(2) be set at a different level for non-multiply listed options? If commenters believe the proposed fee limitation in Rule 610(c)(2) should not apply to fees charged for executions of orders in non-multiply listed options, please explain why and how “non-multiply listed options” should be defined. 18. As proposed, the fee limitation in Rule 610(c)(2) would apply to fees charged for the execution of orders in FLEX options and to the execution of complex orders. 139 Do commenters agree that Rule 610(c)(2) should apply to such transactions? If so, should the proposed fee limitation in Rule 610(c)(2) be set at a different level for orders in FLEX options or complex orders? If commenters believe the proposed fee limitation in Rule 610(c)(2) should not apply to fees charged for the execution of orders in FLEX options or to the execution of complex orders, please explain why. 139 A complex order is any order involving the simultaneous purchase and/or sale of two or more different options series in the same underlying security, for the same account, in a ratio that is equal to or greater than one-to-three (.333) and less than or equal to three-to-one (3.00) and for the purpose of executing a particular investment strategy. See, e.g., ISE Rule 722. See also, e.g., CBOE Rule 6.53C (describing a complex order generally as any of the following orders for the same account, including Spread Orders, Straddle Orders, Strangle Orders, Combination Orders, Ratio Orders, Butterfly Spread Orders, Box/Roll Spread Orders, Collar Orders and Risk Reversals, Conversions and Reversals, and Stock-Option Orders). A flex option is a customized option contract that provides the ability to customize key contract terms, like exercise price, exercise styles and expiration dates. See, e.g., http://www.cboe.com/Institutional/FLEX.aspx; CBOE Rule 24A.4. 19. What would be the impact of the proposed access fee cap in Rule 610(c) on market quality? In particular, the Commission encourages submission of any data that quantifies potential benefits or harm. 20. Do commenters believe that limiting access fees as proposed in Rule 610(c) would have a disparate effect on one type of market model over another? If not, why not? If so, how? And if so, how would the disparate effect impact the ability of exchanges with different market models to compete with each other? The Commission further requests comment as to whether, and if so how, the quoting, order routing or other behavior of market participants would change if the proposed fee cap were in place. For example, as discussed above, several commenters express concern with limiting Take fees without also limiting payment for order flow fees. 140 They argue that market participants on Make or Take exchange quote more aggressively because of the Make rebates paid for providing liquidity that are funded by the Take fees charged to liquidity takers. 141 Exchanges with Make or Take fee models thus provide direct competition based on aggressive quoting to exchanges with payment for order flow models because a market maker on a payment for order flow exchange must match the better prices on the Make or Take exchange, or route to the Make or Take exchange and pay the Take fee. 142 Limiting the amount of a Take fee a Make or Take exchange can charge will directly impact the amount of a Make rebate the exchange can pay to liquidity providers, which in turn will impact a liquidity provider's incentive to quote aggressively, thus limiting the Make or Take exchange's ability to compete with an exchange with a payment for order flow fee model through aggressive quoting. 143 140 See supra note 82 and accompanying text. 141 See BOX Letter, supra note 37, at 3; IB Letter, supra note 37, at 2-3. See also ISE Flash Letter, supra note 73, at 8; and Harris Letter, supra note 128, at 2. 142 See IB Letter, supra note 37, at 3; GETCO Letter, supra note 37, at 6-7. 143 See id. The Commission requests comment on whether commenters agree with this view. Do commenters agree that liquidity providers on Make or Take exchanges quote more aggressively than liquidity providers on other exchanges once their displayed quotations are adjusted to account for the effect of access fees on the “all in” cost to the investor? If so, are liquidity rebates the only reason that liquidity providers on Make or Take exchanges are willing to quote aggressively? For example, does the absence of order flow captured by payments to routing brokers or the absence of guaranteed allocations for liquidity providers also contribute significantly to aggressive quoting by liquidity providers on Make or Take exchanges? Do commenters believe that limiting Take fees, which are a type of access fee, would result in reduced Make rebates paid for supplying liquidity? If so, what are commenters view [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2010-9016. Public record. Not legal advice.