[Federal Register Volume 65, Number 209 (Friday, October 27, 2000)]
[Notices]
[Pages 64466-64468]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-27651]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34 43462; File No. SR-ISE-00-10]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the International Securities Exchange, LLC Relating to 
Payment for Order Flow

October 19, 2000
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on September 12, 2000, the International Securities Exchange, LLC (the 
``Exchange'' or ``ISE'') filed with the Securities and Exchange 
Commission the proposed rule change as described in Items I, II, and 
III below, which items have been prepared by the ISE. The Commission is 
publishing this notice to solicit comments on the proposed rule change 
from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to establish a payment for order flow 
program as follows:
    Authorization To Impose a Payment-for-Order-Flow Fee. The ISE will 
impose fees on Primary Market Makers (``PMMs'') and Competitive Market 
Makers (``CMMs''). There will be up to three separate fees on a per-
contract basis:
     Fees on transactions with Public Customer; \3\
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    \3\ The ISE defines ``Public Customer'' in ISE Rule 100(29).
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     Fees on transactions with Non-Customers \4\ other than 
market makers on another options exchange (``away market makers''); and
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    \4\ The ISE defines ``Non-Customer'' in ISE Rule 100(19).
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     Fees on transactions with away market makers.
    There will not be any fees on transactions in which all parties are 
PMMs and CMMs. The Exchange will establish the specific fees in a 
separate rule filing submitted pursuant to Section 19(b)(3)(A) of the 
Act.\5\ The three fees may be the same, or may differ from each other; 
one or more fees may be set at $0 per contract. The fees on 
transactions with Non-Customers and away market makers may not be 
higher than the fee on Customer transactions, however. In addition, the 
fee on transactions with away market makers will not be higher than the 
fee on transactions with other Non-Customers.
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    \5\ 15 U.S.C. 78s(b)(3)(A).
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    The Exchange also will have the flexibility to establish multi-
tiered fees. These tiers can be based on such factors as the overall 
trading activity of an option, the Exchange's market share in an 
option, or any other objective factor. If the Exchange establishes 
multi-tiered fees, the Exchange's fee filing will specify each of those 
fees.
    Use of the Funds Generated by the Fee to Pay for Order Flow. The 
Exchange will separately account for the funds this fee generates on a 
per-group basis. That is, the Exchange will segregate these funds 
according to each of the groups of ``bins'' of options the Exchange 
trades. The PMMs will use the funds generated by the fee to pay 
Electronic Access Members (``EAMs'') for their order flow. The PMMs 
will have full discretion regarding payments, including which EAMs will 
be paid, the amount of the payments, and the type of order flow subject 
to the payment. The Exchange also will establish ``bin advisory 
committees'' (``BACs'') consisting of the PMM and CMMs in a bin. The 
Exchange will provide to all bin members information regarding payments 
made and the BACs will provide a forum for the discussion of, among 
other things, payment issues. These committees will be advisory in 
nature only, however, and the PMM will retain full discretion over all 
payment decisions.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the ISE included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The ISE has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of the statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The purpose of the proposed rule change is to establish the 
structure for an ISE payment-for-order-flow program. This is a 
competitive response by the Exchange to similar programs of the other 
options exchanges. The proposal has two parts: establishing the 
structure of a fee to fund a payment-for-order-flow program; and 
establishing how the funds the fees generate will be used to pay for 
order flow.
    Establishing a Fee Structure. The Exchange is proposing the 
flexibility of having up to three separate fees. The highest level of 
market maker fees will be on transactions between market makers and 
Public Customers. Because the funds generated will primarily be used to 
pay for customer order flow, the ISE believes that it is reasonable 
that market makers be ``taxed'' primarily on

[[Page 64467]]

their transactions with customers to fund these payments. The structure 
allows for lower fees on Non-Customer transactions and away market 
makers, and there are no fees on transactions executed between ISE 
market makers.
    The ISE states that the possible lower fees on Non-Customers 
reflect a balancing of the competitive interests that currently exist 
in the options markets. The Exchange seeks to encourage market makers 
to provide significant size for Non-Customer orders. If the payment-
for-order flow fee is set at too high a level, however, PMMs and CMMs 
may not provide sufficient size to attract these orders to the 
Exchange. Thus, the Exchange believes that it is important to establish 
a structure that will allow it to establish a balance between 
generating revenue to pay for order flow and attracting Non-Customer 
order flow.
    In addition, the Exchange is proposing a structure that could 
distinguish between orders of away market makers and other Non-
Customers. While the fee could be lower on transactions with away 
market makers than with other Non-Customers, it could not be higher. 
This distinction recognizes certain unique aspects of away market maker 
order flow. In particular, pursuant to the intermarket options linkage 
plan \6\ that the Commission has approved, ISE market makers will have 
certain obligations to trade against the orders of away market makers. 
Thus, the Exchange believes that it may be appropriate to ``tax'' these 
transactions less than other Non-Customer transactions, recognizing 
that these transactions could be in fulfillment of regulatory and 
market obligations and are important in promoting price discovery in 
the market place. This proposal establishes a structure that would 
allow, but not require, the fee to be set in a manner than reflects 
these competitive and market place factors.
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    \6\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000).
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    The proposed rule change also provides that there will not be a fee 
on transactions in which all parties are PMMs and CMMs. Transactions 
between market makers are an important aspect of the ISE's price-
discovery model. These trades often occur when market makers have 
different views on an options price and their quotes interact until a 
``price equilibrium'' is established. In addition, these trades could 
occur as market makers hedge or rebalance their positions. The Exchange 
believes that it would be inappropriate to ``tax'' these trades. Such a 
``tax'' could create incentives to avoid this type of trading, which 
could harm the overall depth, liquidity, and pricing efficiency of the 
ISE's market.
    Finally, the proposal would permit the Exchange to establish 
multiple tiers of fees. The Exchange would define the tiers pursuant to 
objective criteria, including but not limited to the overall activity 
in an option and the Exchange's market share in an option. This is 
intended to provide the ISE with as much flexibility as possible in 
collecting funds to pay for order flow in a manner consistent with the 
Exchange's overall goal of creating incentives for market makers to 
provide deep and liquid markets.
    Payment for Order Flow. The only use of funds generated will be to 
pay for order flow. The Exchange will segregate the funds 
proportionately to the bins that generated the funds, and the PMM in 
each bin generally will have full discretion on how to use those funds 
to pay for order flow. The Exchange will make the payments to the EAMs 
based on the PMM's directives. While the Exchange will establish BACs 
as a forum for CMMs to discuss payment issues with PMMs, CMMs will not 
have any formal role in making payment decisions.
    With respect to members who receive payments for their order flow, 
the Exchange will be issuing appropriate circulars to its members 
emphasizing their disclosure and best execution obligations. The 
Exchange also will be providing to members various reports and other 
information demonstrating the quality of executions that they receive 
on the Exchange.
2. Basis
    The basis for this proposed rule change is the requirement under 
Section 6(b)(5) of the Act \7\ that an exchange have rules that are 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest.
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    \7\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The ISE believes that payment-for-order-flow raises significant 
competitive issues. In the ISE's view, when market makers pay broker-
dealers for their order flow, the true cost of executing orders is 
obscured, imposing a burden on price competition in the market. 
Specifically, the ISE believes that it is difficult to compete for 
order flow when undisclosed payments are influencing order routing 
decisions.
    Furthermore, the ISE believes that these competitive issues are 
compounded when exchanges establish payment-for-order-flow programs. In 
the ISE's view, not only do the payment programs impede price discovery 
and competition on an intermarket basis, but these programs also can 
raise intramarket competitive issues. In this regard, the ISE believes 
that market makers on an exchange should be encouraged to compete 
vigorously within their markets for order flow. Exchange-mandated 
payment-for-order-flow programs require these competitors to act 
jointly in paying broker-dealers for their orders, however. The ISE 
believes that this mandated``tax'' on transactions may well adversely 
affect the ability of individual market makers to compete as vigorously 
as possible for order flow through aggressive quotations, thus harming 
intra market price competition. Moreover, in the ISE's view, to the 
extent that market makers do ``compete'' by paying for order flow, such 
payments may or may not flow through to the ultimate investor. In 
contrast, aggressive quotation competition clearly would flow through 
to investors.
    Notwithstanding these concerns, the ISE believes that it must 
establish a level playing field on which it can compete with the other 
options exchanges, all of which have developed their own payment for 
order flow programs. Accordingly, the Exchange believes that this 
proposed rule change does not impose any burden on competition that is 
not necessary or appropriate in furtherance of the purposes of the Act.
    As noted below, the Commission has permitted payment-for-order-flow 
programs on all four competing options exchanges to take effect 
pursuant to effective-on-filing rule changes. While the Commission has 
the authority to abrogate those filings, it has not exercised that 
authority.\8\ In the ISE's view, the burden on competition resulting 
from payment-for-order-flow already is present in the market, and 
therefore any incremental effects of the ISE's program will be minimal. 
The ISE believes, moreover, that it will be at a competitive 
disadvantage, at least in the short term, if it is not permitted to 
offer a competitive program. Accordingly, the ISE believes that there 
is no basis under

[[Page 64468]]

the Act to impose such an anticompetitive burden upon it.
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    \8\ The ISE urged the Commission to abrogate the first of these 
filings, which was submitted by the Chicago Board Options Exchange. 
See letter dated July 14, 2000 from Michael Simon, Senior Vice 
President and Secretary, ISE, to Jonathan G. Katz, Secretary, SEC.
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C. Self-Regulatory Organziation's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The Exchange has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register (or within such longer period as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or as to which 
the ISE consents), the Commission shall by order approve this proposed 
rule change or institute proceedings to determine whether the proposed 
rule change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of the filing will also be 
available for inspection and copying at the principal office of the 
ISE. All submissions should refer to File No. SR-ISE-00-10 and should 
be submitted by November 17, 2000.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\1\
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    \1\17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-27651 Filed 10-26-00; 8:45 am]
BILLING CODE 8010-01-M