[Federal Register Volume 66, Number 17 (Thursday, January 25, 2001)]
[Notices]
[Pages 7822-7826]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-2243]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43833; File No. SR-ISE-00-10]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the International Stock Exchange, LLC Relating to Payment for 
Order Flow

January 10, 2000.

I. Introduction

    On September 12, 2000, the International Securities Exchange, LLC 
(``ISE'' or ``Exchange''), filed with the Securities and Exchange 
Commission (``Commission'') pursuant to section 19(b)(1) of the 
Securities Exchange Act

[[Page 7823]]

of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule 
change to adopt a payment-for-order-flow fee program designed to 
attract options order flow to the Exchange.\3\ Notice of the proposed 
rule change was published for comment in the Federal Register on 
October 27, 2000.\4\ The Commission received ten comment letters 
regarding the proposal.\5\ This order approves the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In the interim, the ISE submitted another proposed rule 
change concerning a fee to fund payment for order flow, File No. SR-
ISE-00-24, which became effective upon its filing on December 1, 
2000. See Securities Exchange Act Release No. 43688 (Dec. 7, 2000), 
65 FR 78233 (Dec. 14, 2000). The interim proposal established a fee 
of $.75 per contract on all Primary Market Maker and Competitive 
Market Maker executions against customer orders, which is to 
terminate at the earlier of January 15, 2001, or Commission approval 
of the ISE's permanent program discussed in this release and the 
ISE's establishment of a fee to fund the permanent program.
    \4\ See Securities Exchange Act Release No. 43462 (October 19, 
2000), 65 FR 64466.
    \5\ See Letters to Jonathan G. Katz, Secretary, the Commission, 
from: Edward Frank, Managing Director, Gateway Partners, LLC, dated 
September 22, 2000 (``Gateway Letter''); Bernard L. Hirsh, President 
and market maker, Bernard L. Hirsch, Inc., dated September 28, 2000 
(``Hirsh Letter''); Meyer S. Frucher, Chairman and Chief Executive 
Officer, Philadelphia Stock Exchange (``Phlx''), dated November 1, 
2000; Joel Greenberg, Chief Legal Officer, Susquehanna Investment 
Group (``Susquehanna''), dated November 13, 2000; Merrill G. 
Davidoff, Berger & Montague, P.C., on behalf of Independent Traders 
Association, Inc., dated November 9, 2000 (``ITA Letter''); Matthew 
D. Wayne, Chief Legal Officer, Knight Financial Products, LLC (``KFP 
Letter''), dated November 16, 2000; and Edward J. Joyce, President 
and Chief Operating Officer, Chicago Board Options Exchange 
(``CBOE''), dated November 21, 2000 (``CBOE Letter''); and to Arthur 
Levitt, Chairman, the Commission, from: Daniel C. Bigelow, 
President, Binary Traders, LP, et al., dated September 29, 2000 
(``Binary Traders Letter''); and Marjorie McGee, market maker, 
Benton Parnters, dated September 29, 2000 (``McGee Letter'').
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II. Description of the Proposal

    The proposed rule change will establish the structure for an ISE 
payment-for-order-flow program, as a competitive response by the 
Exchange to similar programs at the other options exchanges.\6\ The 
proposal includes two major elements:
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    \6\ The Commission notes that since July 2000, all five options 
exchanges have submitted fee proposals to the Commission, which 
became effective on filing, that impose fees on market makers to 
fund payment for order flow. See Securities Exchange Act Release 
Nos. 43112 (August 3, 2000), 65 FR 49040 (August 10, 2000) (SR-CBOE-
00-28); 43177 (August 18, 2000), 65 FR 51889 (August 25, 2000) (SR-
Phlx-00-77); 43228 (August 30, 2000), 65 FR 54330 (September 7, 
2000) (SR-Amex-00-38); 43290 (September 13, 2000), 65 FR 57213 
(September 21, 2000) (SR-PCX-00-30); and supra note 3 (concerning 
the ISE's interim filing).
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A. Establishing a Payment-for-Order-Flow Fee

    Under the proposed rule change, the ISE will be authorized to 
impose fees on Primary Market Makers (``PMMs'') and Competitive Market 
Makers (``CMMs''). The proposal allows for up to three separate fees on 
a per-contract basis:

     Fees on transactions with Public Customers;\7\
     Fees on transactions with Non-Customers,\8\ other than 
market makers on another options exchange (``away market makers''); 
and
     Fees on transactions with away market makers.

    No fees are authorized under the proposal for transactions in which 
all parties to the transaction are PMMs and/or CMMs.
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    \7\ ``Public Customer'' is defined by ISE Rule 100(29) as ``a 
person that is not a broker or dealer in securities.''
    \8\ ``Non-Customer'' is defined by ISE Rule 100(19) as ``a 
person or entity that is a broker or dealer in securities.''
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    The proposal provides that the specific amounts of the fees 
authorized under its provisions are to be established in a separate 
rule filing submitted to the Commission pursuant to Section 19(b)(3)(A) 
of the Act.\9\ The three fees may be the same, or may differ from each 
other; one or more fees may be set at $0.00 per contract. The fees on 
transactions with Non-Customers and away market makers may not be 
higher than the fee on Public Customer transactions, however. In 
addition, the fee on transactions with away market makers may not be 
higher than the fee on transactions with other Non-Customers.
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    \9\ 15 U.S.C. 78s(b)(3)(A).
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    The Exchange also will have the flexibility under the proposed rule 
change to establish multi-tiered fees. This means that the fees may 
vary according to the option traded.\10\ The tiers may 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.
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    \10\ Telephone conversation between Michael J. Simon, Senior 
Vice President and General Counsel, ISE, and Nancy J. Sanow, 
Assistant Director, and Ira L. Brandriss, Attorney, Division of 
Market Regulation, the Commission, on November 8, 2000 (``Telephone 
conversation with the ISE'').
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B. Use of the Funds

    Under the proposed rule change, the Exchange will separately 
account for the funds the payment-for-order-flow fee generates on a 
per-group basis. That is, the Exchange will segregate these funds 
according to each of the groups--or ``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 those EAMs to 
be paid, the amount of the payments, and the type of order flow subject 
to the payment.
    The proposed rule change also provides that the Exchange will 
establish ``bin advisory committees'' (``BACs'') consisting of the 
particular 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 payment-for-order-flow issues.\11\ These 
committees will be advisory in nature only, however, and the PMM will 
retain full discretion over all payment decisions.
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    \11\ BACs are intended to provide the PMM and CMMs comprising a 
bin solely with the means to discuss advice and suggestions on 
payment-for-order-flow issues and will not be used for any other 
purpose. Telephone conversation with the ISE.
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III. Comment Letters

    The proposal was opposed by four commenters, including a specialist 
and market maker firm that is a member of all the national options 
exchanges,\12\ a member firm of both the ISE and the Phlx; \13\ a 
former floor broker who is currently a market maker on the Phlx; \14\ 
and an association of options market makers recently formed, in part, 
to challenge the propriety of payment for order flow as implemented by 
the Phlx.\15\
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    \12\ See Gateway Letter.
    \13\ See Binary Traders Letter.
    \14\ See McGee Letter.
    \15\ See ITA Letter.
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    Generally, these commenters maintained that payment for order flow 
harms investors because brokers who receive payment to direct their 
order flow to a specific specialist or exchange have no incentive to 
seek the best price for their customers, and because market centers 
that pay for order flow may not compete as aggressively for orders on 
the basis of price.\16\ The opponents argued further that the increased 
costs of paying for order flow would be unaffordable to smaller market 
participants and could lead to an exodus of market makers from the

[[Page 7824]]

market.\17\ This would reduce liquidity and competition in the markets, 
thereby causing spreads to widen and harming investors, they believed. 
Some also feared that the large firms that survived would form cartels 
to eliminate their competition.\18\
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    \16\ Two commenters believed that the ``prearranged trading'' 
implicit in payment-for-order-flow arrangements could violate 
Commission rule and/or federal criminal statutes. See Binary Traders 
Letter, McGee Letter. One commenter argued that market makers who 
believe that payment for order flow is unethical should not be 
compelled by an exchange to help fund the practice. See Gateway 
Letter.
    \17\ Two commenters claimed that plans for distribution of the 
funds are designed to exclude many firms providing the money, 
``effectively putting exchanges in the position of deciding who will 
stay in business and who will not be able to afford to maintain 
operations.'' See Binary Traders Letter, McGee Letter.
    \18\ See Binary Letter, McGee Letter. See also ITA Letter.
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    Some commenters were also concerned about the discretion granted to 
the PMM in appropriating the funds generated by the fee.\19\ They 
argued that the proposal obligates CMMs to pay a fee that their 
competitor, the PMM, can use to benefit itself--through direct payment 
relationships and the favored treatment that can arise from such 
relationships--and possibly in ways hidden from the CMMs.\20\
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    \19\ See, e.g., Gateway Letter, ITA Letter.
    \20\ One commenter claimed that the PMM would also be able to 
benefit by using documentation of the fees it could expect to have 
at its discretion as a credit, cash or voucher at another exchange. 
See Gateway Letter. Another commenter argued that specialists that 
operate on multiple exchanges would have divided loyalties and 
economic interests, and thus would lack sufficient incentive to use 
the funds collected at a particular exchange in a way that would 
promote that exchange's competitive interest. See ITA Letter.
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    Another commenter, an independent Registered Options Trader on the 
Phlx, predicted some of the same outcomes feared by the proposal's 
opponents, but did not specifically take a position of whether the 
proposal should or should not be approved.\21\
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    \21\ Hirsh Letter. The commenter also believed that under the 
proposal, market makers and specialists would tend to cooperate more 
than compete; brokers would promote increased options trading by 
their customers in order to reap the benefit of payment for order 
flow; smaller exchanges would increase their market share; and the 
exchanges and market participants involved in payment-for-order-flow 
arrangements would face litigation attacking their ``collaboration'' 
as ``subversive to the auction market and harmful to the 
customers.''
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    The Phlx did not oppose the ISE proposal, believing that its impact 
would be minimal in view of the fact that other exchanges have already 
implemented similar payment-for-order-flow fees. However, as a general 
matter, the Phlx voiced the view that ``exchange-sponsored payment for 
order flow programs'' are anti-competitive, interfere with market 
forces, adversely impact market makers, interfere with the obligation 
of exchanges to supervise for best execution of customer orders, and 
are structural impediments to price competition.
    While not objecting to the language of the ISE proposal, Knight 
Financial Products (``KFP'') commented that ``[e]xchange sponsored 
payment for order flow programs are not in the best interests of the 
securities industry.'' It added: ``To the extent the payment for order 
flow should even exist in the options industry, it should be a decision 
made by market makers and/or specialists and not the exchanges.'' At 
the same time, KFP believed that if the Commission allows the current 
status quo to continue, it should approve the ISE proposal to allow the 
ISE to remain competitive.
    The CBOE believed that fairness dictates that the ISE's proposed 
rule change be approved, but took issue with what it viewed as 
misstatements in the proposal. Specifically, the CBOE disagreed with 
the ISE's belief that payment-for-order-flow programs sponsored by 
exchanges have a more detrimental effect on intramarket competition 
than other payment-for-order-flow plans.\22\
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    \22\ CBOE Letter.
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    Susquehanna believed that the proposal raises numerous antitrust 
issues, concerning, for example, the sharing of information on payment 
for order flow among market participants; the determination of who will 
be permitted to participate in the discussions; and the establishment 
of different fees for different types of transactions. Susquehanna 
believed that the Commission should establish guidelines under which 
market participants may participate in option exchange payment-for-
order-flow plans and indicate whether such guidelines will provide any 
immunity to market participants or exchanges under U.S. antitrust laws.

IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the provisions of the Act and the rules thereunder applicable to a 
national securities exchange. The Commission believes the proposal is a 
reasonable competitive response on the part of the ISE to the adoption 
of similar payment-for-order-flow programs on other exchanges.
    Specifically, the Commission believes that the proposed rule change 
provides for the equitable allocation of a reasonable fee among the 
ISE's members in accordance with Section 6(b)(4) of the Act,\23\ 
designed, as it is, to enable the Exchange to compete with other 
markets in attracting options business. In conformance with Section 
6(b)(8) of the Act,\24\ the proposal, rather than imposing an 
unnecessary burden on competition, should serve to even the playing 
field among competing exchanges.
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    \23\ 15 U.S.C. 78f(b)(4).
    \24\ 15 U.S.C. 78f(b)(8).
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    As required by section 6(b)(5) of the Act,\25\ the proposed rule 
change is not designed to permit unfair discrimination among market 
participants. The proposal's differentiation of fees based on the types 
of transactions and according to the tiers described above is grounded 
upon a satisfactory rationale. No distinctions are made among Exchange 
members with respect to the amounts they must pay based on any factor 
other than the nature of the transaction upon which the fee is imposed 
and the trading characteristics of the particular option that it 
involves, as assessed in terms of objective criteria.
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    \25\ 15 U.S.C. 78f(b)(5)
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    The Commission notes, in approving the proposed rule change, that 
the U.S. options markets are in the midst of profound and dynamic 
structural change, resulting from the intense competition for options 
order flow unleashed by the multiple listing of the most actively 
traded options beginning in August 1999. The creation of the ISE as the 
nation's newest options exchange, with plans to list some 600 
standardized options classes traded on other markets, has also 
contributed in no small measure to the new competitive environment.
    The heightened competition among markets and market participants 
for order flow, and the shifting order flow patterns it produces, shows 
no signs of abating. Payment for order flow--long a controversial facet 
of competition in the equities markets--has now emerged as a phenomenon 
in the options markets, as well.
    As noted in a recently released Commission study, Payment for Order 
Flow and Internalization in the Options Markets (``SEC Study''),\26\ 
the offering of direct cash compensation to broker-dealers to route 
their orders to a particular market center is, in fact, one of several 
strategies based on economic inducement to which exchanges and 
specialists have resorted in the intense competition to win orders.\27\
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    \26\ See ``SEC Staff Report Describes Development of Payment for 
Order Flow and Internalization in the Options Markets,'' Commission 
press release 2000-190, December 20, 2000; the full report, prepared 
by the Commission's Office of Compliance Inspections and 
Examinations and Office of Economic Analysis, is available at http://www.sec.gov/news/studies/ordpay.htm.
    \27\ Other strategies identified in the SEC Study include: (1) 
Exchange rules that permit order-routing firms to ``internalize'' 
part of their orders, i.e., trade as principal against at least a 
portion of their own customers' orders ahead of the trading crowd on 
the floor of the exchange, thus reaping higher profits than they 
would realize as mere agents; (2) another form of internalization, 
in which a broker-dealer affiliated with a specialist firm 
determines to route all its orders in a particular option to the 
exchange where that firm serves as specialist in the option; and (3) 
reciprocal order-routing arrangements, whereby, for instance, a 
specialist agrees to send a particular broker-dealer the equities 
orders it receives in return for the broker-dealer routing to the 
specialist the options orders it receives. See also infra, note 29.

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[[Page 7825]]

    Both public customers and securities industry professionals have 
voiced deep concerns about this practice. The Commission, too, has 
repeatedly recognized--most recently, in the SEC Study--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 quote competition. At the same time, 
paying for order flow is not in itself unlawful, and the Commission has 
acknowledged that it 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.\28\
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    \28\ See, e.g., Securities Exchange Act Release No. 42450 
(February 23, 2000), 65 FR 10577 (February 28, 2000).
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    Payment for order flow assumes many different forms and guises--as 
numerous as the many different kinds of incentives granted to order 
flow providers by exchanges, specialists, and other market participants 
to order flow providers to entice them to send their business to 
them.\29\ Without more, this form of such payment or incentive--however 
objectionable to some--cannot be said to be in itself inconsistent with 
the Act while other forms are accepted as consistent with the Act.\30\ 
In this context, the ISE proposal cannot be said to constitute an undue 
burden on competition.
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    \29\ For instance, Commission rules under the Act define payment 
for order flow broadly as:
    any monetary payment, service, property, or other benefit that 
results in remuneration, compensation, or consideration to a broker 
or dealer from any broker or dealer, national securities exchange, 
registered securities association, or exchange member in return for 
the routing of customer orders by such broker or dealer * * * 
including but not limited to: Research, clearance, custody, products 
or services; reciprocal agreements for the provision of order flow; 
adjustment of a broker or dealer's unfavorable trading errors; 
offers to participate as underwriter in public offerings; stock 
loans or shared interest accrued thereon; discounts, rebates, or any 
other reductions of or credits against any fee to, or expense or 
other financial obligation of, the broker or dealer routing a 
customer order that exceeds that fee, expense, or financial 
obligation.
    See Rule 10b-10(d)(9), 17 CFR 240.10b-10(d)(9), incorporated by 
reference in the definitional section of recently approved Rule 
11Ac1-6, 17 CFR 240.11Ac1-6 (effective date, January 30, 2001), 
which imposes new disclosure requirements on broker-dealers 
concerning their order routing practices, including payment for 
order flow arrangements. The new rule is applicable to both equity 
securities and options transactions. See Securities Exchange Act 
Release No. 43590 (November 17, 2000), 65 FR 75414 (December 1, 
2000) (``Disclosure of Routing Practices Adopting Release''). See 
also supra, note 27.
    \30\ The Commission notes in this regard that several securities 
exchanges have adopted various programs in which the exchanges 
themselves grant economic inducements to members in an attempt to 
attract additional equity order flow to their markets. See, e.g., 
Securities Exchange Act Release No. 41286 (April 14, 1999), 64 FR 
19843 (April 22, 1999) (concerning specialist revenue sharing 
program at the Chicago Stock Exchange) and other programs cited in 
that release at note 8.
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    The strict proviso, however--as already mentioned--is that adequate 
protections must be established to assure that order flow providers 
meet their duty of best execution to their customers. In approving the 
ISE's proposed rule change, the Commission expects the Exchange to 
issue appropriate informational materials to its members that emphasize 
the best execution obligations of EAMs who may accept payment for order 
flow.
    Moreover, the Commission notes that new Rule 11Ac1-6 under the Act, 
``Disclosure of Order Routing Information,'' will require broker-
dealers to make publicly available, for each calendar quarter, a report 
on how it routes its customer orders, including options orders.\31\ 
That report must include a description of any payment for order flow 
arrangements the broker-dealer maintains with market centers to which 
it sends significant percentages of its orders.\32\ The Commission 
believes that making these arrangements visible will encourage broker-
dealers' compliance with their best execution obligations.
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    \31\ 17 CFR 240.11Ac1-6. The Rule becomes effective January 30, 
2001, while broker-dealers must comply with its provisions beginning 
July 2, 2001. See Disclosure of Routing Practices Adopting Release, 
Section V.
    \32\ See 17 CFR 240.11Ac1-6(b)(1)(iii) and Disclosure of Routing 
Practices Adopting Release, Section IV.B.
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    The Commission acknowledges the broader concern that payment for 
order flow may result in less aggressive competition for order flow on 
the basis of price, articulated in the comment letters.\33\ However, 
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.
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    \33\ Some of the findings of the recent SEC Study tend to 
validate this concern, although the study emphasized that continued 
monitoring of the markets is necessary.
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    It therefore would be unfair to disapprove the payment for order 
flow program proposed by the ISE as a salve to the issues created by 
payments, rebates, credits, and other incentives to encourage order 
flow that now exist across both equity and options markets.
    With respect to the concern voiced by Susquehanna that the proposal 
raises antitrust issues, the ISE has represented that the discussions 
among CMMs and PMMs in the BACs established under the proposal will be 
limited strictly to the subject of payment to order flow providers from 
the funds generated by the collected fees. Although Susquehanna urged 
the Commission to provide guidelines on option exchange payment-for-
order-flow programs from an antitrust perspective, the Commission 
believes that market participants should consult their own legal 
counsel on antitrust issues.
    With respect to the argument of some market makers that payment-
for-order-flow fees are unaffordable, the Commission believes that the 
determination to impose them is a business decision legitimately made 
by the Exchange in assessing the costs that must be assumed if it is to 
remain competitive as a market center. With respect to other concerns 
voiced by the commenters, the Commission expects that the ISE, in 
fulfillment of its self-regulatory function, will be alert to any 
inappropriate expenditure of such funds in the service of particular 
members, or for use of these funds to encourage trades on other 
exchanges.

V. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act and the rules and regulations 
thereunder.
    It Is Therefore Ordered, pursuant to section 19(b)(2) of the Act, 
that the proposed rule change (SR-ISE-00-10) be and hereby is approved.


[[Page 7826]]


    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\34\
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    \34\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-2243 Filed 1-24-01; 8:45 am]
BILLING CODE 8010-01-M