[Federal Register Volume 69, Number 26 (Monday, February 9, 2004)]
[Proposed Rules]
[Pages 6124-6138]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-2646]



[[Page 6123]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 240



Competitive Developments in the Options Markets; Proposed Rule

  Federal Register / Vol. 69 , No. 26 / Monday, February 9, 2004 / 
Proposed Rules  

[[Page 6124]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-49175; File No. S7-07-04]
RIN 3235-AJ15


Competitive Developments in the Options Markets

AGENCY: Securities and Exchange Commission (``SEC'' or ``Commission'').

ACTION: Concept release; request for comments.

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SUMMARY: This Concept Release discusses changes in the options markets 
that have occurred since the start of widespread multiple trading of 
options that have had the greatest impact on competition. It also seeks 
comment on whether the Commission should take any action to improve the 
efficiency of the options markets and mitigate the conflicts of 
interest that may be impeding price competition in those markets.

DATES: Comments should be received by April 9, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by hard copy or e-mail, but not by 
both methods. Comments sent by hard copy should be submitted in 
triplicate to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street NW., Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following e-mail address: 
[email protected]. All comment letters should refer to File No. S7-
07-04. This file number should be included in the subject line if e-
mail is used. All comments received will be posted on the Commission's 
Internet Web site (http://www.sec.gov) and made available for public 
inspection and copying in the Commission's Public Reference Room, 450 
Fifth Street NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: Elizabeth King, Associate Director, at 
(202) 942-0140, Richard Strasser, Attorney Fellow, (202) 942-0737, 450 
Fifth Street NW., Washington, DC 20549-1001.

Table of Contents

I. Introduction
II. Overview of Recent Changes
    A. Traditional Options Market Structure
    B. Start of Multiple Listing
    C. A New Options Exchange
III. Impact of Enhanced Competition
    A. Narrower Spreads
    B. Marketplace Innovations
    1. Expansion of Auto-Ex Systems
    2. Enhanced Automation of Trading on Floor-Based Exchanges
    3. Displaying Size in Quotes
    4. Automated Systems that Enhance IntraMarket Quote Competition
    C. Payment for Order Flow, Specialist Guarantees, and 
Internalization
    1. Payment for Order Flow Arrangements
    2. Specialist Guarantees
    3. Internalization
IV. Concerns with Payment for Order Flow, Specialist Guarantees, and 
Internalization
    A. Quote Competition
    B. Best Execution
    C. Conflicts between the Roles of Market and SRO
V. Regulatory Initiatives
    A. Exchange Act Rule 11Ac1-6
    B. Decimals
    C. Intermarket Linkage
    D. Applying the Quote Rule to Options
    E. Enforcement Settlement
VI. Additional Steps that Could Be Taken to Address Concerns about 
Payment for Order Flow, Specialist Guarantees, and Internalization
    A. Should the Commission Take Action at this Point?
    B. Should the Commission Require Brokers to Rebate All or a 
Portion of Payments They Receive?
    C. Should the Commission Ban Payment for Order Flow, Specialist 
Guarantees, and Internalization?
    D. Should the Commission Ban Only Exchange-Sponsored Payment for 
Order Flow?
    1. Phlx Petition
    2. Susquehanna Request
    E. Should the Commission Establish Uniform Rules and Enforcement 
Standards Regarding Internalization and Specialist Guarantees?
    F. Should the Commission Apply Rule 11Ac1-5 to Options?
    G. Would Penny Quotes in Options Reduce Payment for Order Flow?
    H. Should the Commission Apply the Limit Order Display Rule to 
Options?
VII. Solicitation of Additional Comments

I. Introduction

    Competition among U.S. options exchanges dramatically expanded in 
the fall of 1999 when these markets began to compete by trading many of 
the same options products. This competition has had a number of 
benefits. Soon after this competition among the markets began, however, 
order entry firms started seeking opportunities to trade with their 
orders or be paid for their order flow from the competing markets. 
Since that time, payment for order flow and internalization of orders 
have become commonplace.
    While there has been a great deal of informal discussion about the 
ways in which payment for order flow and internalization impact the 
options markets and other market participants, the Commission has not 
yet formally requested public comment on these and other similar 
practices, such as specialist participation guarantees, and whether 
these practices raise concerns. This Concept Release discusses the 
changes in the options markets since the start of widespread multiple 
trading of options that have had the greatest impact on competition. It 
also seeks comment on whether the Commission should take any action to 
improve the efficiency of the options market and mitigate the conflicts 
of interest that may be impeding price competition in those markets.

II. Overview of Recent Changes

A. Traditional Options Market Structure

    Prior to the start of widespread multiple listing of equity options 
in 1999, the options exchanges then in operation (the American Stock 
Exchange (``Amex''), Chicago Board Options Exchange (``CBOE''), Pacific 
Exchange (``PCX'') and Philadelphia Stock Exchange (``Phlx''), 
collectively, ``floor-based options exchanges'') had priority rules 
that allocated trades among competing market participants on their 
floors. Some of these allocation methods were designed to enhance price 
competition, while others were designed to achieve other purposes, such 
as rewarding specialists or market makers for providing liquidity to 
the market.
    To facilitate price competition on these markets, orders sent to 
the floors of each of the exchanges generally were exposed to an 
auction before a specialist and other market participants, including 
market makers and floor brokers in the crowd. Generally, contracts were 
allocated to the market participants in the following order: (1) The 
first identifiable bid or offer at the best price and (2) all other 
market participants on parity with the best bid or offer. This 
allocation principle was designed to promote price competition by 
rewarding market participants willing to set the best price.
    Nevertheless, the options exchanges deviated from price-time 
priority to achieve other goals. For example, the exchanges developed 
specialist guarantees to reward specialists for committing capital on 
the exchange floor. Specialist guarantees give priority to a specialist 
over other market makers by allocating a certain percentage of each 
order to the specialist when that specialist's quote is equal to the 
best price quoted on the exchange.\1\ In addition, the options 
exchanges provided limited opportunities for upstairs firms to trade 
with large

[[Page 6125]]

customer orders where the crowd chose not to trade with them.\2\
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    \1\ See infra notes 46-50 and accompanying text.
    \2\ See infra notes 51-53 and accompanying text. This release 
uses the term ``upstairs firm'' to mean a broker-dealer that is 
seeking to facilitate or trade with its own public customer's 
options order on an exchange upon which the broker-dealer is a 
member. The broker-dealer may or may not be affiliated with the 
specialist in the option issue that is the subject of the customer 
order.
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    In addition, the options exchanges developed automated execution 
(``auto-ex'') facilities to execute smaller orders quickly and 
efficiently at the prevailing bid or offer without first exposing those 
orders to an auction. These orders were automatically executed at the 
exchange's disseminated price, which in almost all cases was the price 
generated by the specialist's auto-quote.\3\ Under a traditional 
options market structure, the specialist is the only market maker on 
the exchange with the capability to auto-quote, and these quotes are 
considered the quotes of all the market makers in the crowd.\4\ 
Exchange rules generally permit a market maker to improve the price 
established by the specialist's auto-quote by announcing the better 
price in the crowd. The specialist (or an exchange quote reporter) then 
manually reflects this better price in the exchange's disseminated 
quote. This manual process is cumbersome, permitting market makers to 
improve the quote only in one series of an option at a time.\5\ In 
addition, until recently, there was little incentive to improve the 
quote generated by the specialist's auto-quote because exchange rules 
allocating automatically executed orders did so regardless of whether a 
particular market maker improved the quote.\6\
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    \3\ This release uses the term ``auto-quote'' to refer to an 
electronic system specialists and other market makers use that 
automatically monitors and instantly updates quotations using a 
mathematical formula measuring certain characteristics of the 
options and underlying interest. This formula is based on a number 
of components that impact the value of the option, such as 
volatility, interest rate, and dividend. See, e.g., Phlx Rule 1080, 
Commentary .01(a)-(b).
    \4\ See e.g., Exchange Act Release No. 47959 (May 30, 2003), 68 
FR 34441, 34442 (June 9, 2003) (approving SR-CBOE-2002-05).
    \5\ See, e.g., Exchange Act Release No. 45677 (March 29, 2002), 
67 FR 16476 (April 5, 2002) (approving SR-CBOE-2002-07). Any member 
of the trading crowd who submits a manual quote that improves an 
exchange's disseminated quote is considered to be a responsible 
broker or dealer under Rule 11Ac1-1(c) under the Act and it must be 
firm for the price of its quote up to its disseminated size. Rule 
11Ac1-1(b) under the Act requires the exchange that receives the 
manual quote to disseminate it. Id.
    \6\ Id. As discussed below, the floor-based options exchanges 
reached a settlement with the Commission resulting from an 
enforcement action that requires, among other things, that those 
exchanges amend their existing rules governing their automated 
quotation and execution systems to increase incentives to quote 
competitively. See infra note and accompanying text.
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B. Start of Multiple Listing

    From 1977 until August 1999, most actively traded options were 
listed on only one exchange.\7\ Moreover, unlike in equity securities, 
there is no over-the-counter market for standardized options. 
Consequently, firms had no choice as to where to send a customer's 
order for such singly listed options. The Commission has long held the 
view that multiple listing of equity options, subject to the 
Commission's oversight under the national market system, could spur 
competition among options markets to provide more efficient trading 
services resulting in lower transaction costs for investors.\8\ To 
promote multiple listing, the Commission adopted Exchange Act Rule 19c-
5 in 1989.\9\
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    \7\ In August 1999, 32% of equity options were traded on more 
than one exchange. By September 2000, that number had risen to 45%. 
Over the same period, the percentage of aggregate option volume 
traded on only one exchange fell from 60% to 15%. Exchange Act 
Release No. 43085 (July 28, 2000), 65 FR 47918, 47919 (August 4, 
2000) (proposing to extend Exchange Act Rule 11Ac1-1 to options). 
According to the Options Clearing Corporation, by September 2003, 
98.3% of equity options traded on more than one exchange. For a 
discussion of the early development of multiple trading in the 
options markets see Exchange Act Release No. 24613 (June 18, 1987), 
52 FR 23849 (June 25, 1987) (proposing Exchange Act Rule 19c-5).
    \8\ See, e.g., Exchange Act Release No. 22026 (May 8, 1985), 50 
FR 20310 (May 15, 1985).
    \9\ See Exchange Act Release No. 26870 (May 26, 1989), 54 FR 
23963 (June 5, 1989).
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    Rule 19c-5 prohibits exchanges from having rules that limit their 
ability to list any stock options class because that options class is 
listed on another options exchange. Nevertheless, most options did not 
begin trading on multiple markets until August 1999.\10\ Today, 
virtually all actively traded equity options trade on multiple markets, 
a development that has enhanced competition among the options 
exchanges.
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    \10\ For a discussion of some of the factors that may have 
contributed to the multiple listing of actively traded options, see 
``Poachers take stock, then wait and watch for more options: CBOE's 
trading of Dell has put even more pressure on U.S. exchanges to 
abandon their `gentlemen's agreement,' '' Financial Times p. 26 
(August 26, 1999).
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C. A New Options Exchange

    The launch of the International Securities Exchange (``ISE'') in 
May 2000, the first new exchange in over two decades, further 
intensified competition.\11\ ISE introduced to the U.S. a market model 
for options in which multiple market makers on the exchange quote 
independently.\12\ ISE's disseminated prices are the result of this 
intramarket competition.
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    \11\ The ISE trades 597 options issues. Trading in these issues 
across all options exchanges represents about 90% of options 
industry volume. See http://www.iseoptions.com (Dec. 14, 2003).
    \12\ Under ISE's rules, one Primary Market Maker (``PMM'') and 
at least two Competitive Market Makers (``CMMs'') are assigned to 
each options class traded on the exchange. ISE Rule 802(c). Among 
other obligations, a PMM must enter continuous, two-sided quotes in 
all of the options classes to which it is assigned. A CMM must 
participate in the opening and make markets and enter into any 
resulting transaction on a continuous basis in at least 60% of the 
options classes in the group of classes to which it is assigned. ISE 
Rule 804. CMMs are able to stream their quotes on ISE 
electronically. By contrast, until recently, the floor-based options 
exchanges' disseminated quotes represented only the auto-quote price 
of the specialist or specialist-equivalent. The other market makers 
could effect changes in that quote only through open outcry or 
through the manual entry of quotes. See, e.g., Exchange Act Release 
No. 47676 (April 14, 2003), 68 FR 19865, 19866 (April 22, 2003) (SR-
CBOE-2002-05, proposing to establish CBOE's hybrid trading system).
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    Greater competition among options exchanges for order flow has 
manifested itself in many ways. Exchange transaction fees for customers 
have all but disappeared. Spreads are narrower. Markets have expanded 
and enhanced the services they offer and introduced innovations to 
improve their competitiveness. At the same time, inducements to order 
flow providers, including payment for order flow and internalization 
opportunities, have increased.

III. Impact of Enhanced Competition

A. Narrower Spreads

    One of the most palpable results of enhanced competition in the 
options markets is the narrowing of spreads. Lower spreads can provide 
better prices for investors. In December 2000, the Commission staff 
issued the results of a preliminary study of one-week periods from 
August 1999 (a benchmark period prior to widespread multiple listing of 
actively traded options) and October 2000 (a benchmark period during 
which the actively traded options in the study were listed on more than 
one exchange) to determine, among other things, how multiple listing 
impacted quote competition and spreads in the options markets.\13\ The 
staff found that average exchange-quoted spreads (i.e., intraexchange 
spreads, representing the bid and the offer of one exchange) for the 
most actively traded options (i.e., those under $20) decreased by 8% 
from the August 1999 period to the October 2000 period. Exchange-quoted 
spreads indicate how aggressively the market participants on individual 
exchanges

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are setting their quotes. Quoting across exchanges over this period 
showed a much more dramatic change. The trade-weighted consolidated 
national best bid and offer (``NBBO'')\14\ spreads fell from $0.29 in 
August 1999 to $0.18 in October 2000, a decline of nearly 38%.\15\
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    \13\ Special Study: Payment for Order Flow and Internalization 
in the Options Markets, Office of Compliance Inspections and 
Examinations and Office of Economic Analysis (Dec. 2000) [``SEC 
Staff Special Study''].
    \14\ The NBBO is the interexchange best bid or offer, where each 
side of the best bid and offer, regardless of the quoting exchange, 
is used. Although an NBBO was not calculated for the options markets 
at the time the study was conducted, the SEC staff calculated one 
for purposes of the study.
    \15\ The SEC Staff Special Study concluded that, in addition to 
multiple listing, the drop in the consolidated NBBO spread also 
could have been attributed, at least in part, to the entrance of ISE 
into the market at that time. See SEC Staff Special Study, supra 
note 13 at text accompanying notes 72-73.
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    The actual transaction costs that investors paid for their options 
executions (measured by effective spreads) also declined from the 
August 1999 period to the October 2000 period.\16\ The average 
effective spread for options priced below $20 was $0.21 in August 1999 
and $0.17 in October 2000, a decline of approximately 19%. The most 
dramatic decline, however, was witnessed in smaller orders (typically 
orders of 50 or fewer contracts). For those orders, which are eligible 
for automatic execution, the average effective spread fell from $0.26 
in August 1999 to $0.17 in October 2000, a drop of nearly 35%.
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    \16\ The effective spread is twice the absolute difference 
between the trade price and the midpoint of the bid-ask spread at 
the time the trade report was received by the Options Price 
Reporting Authority. The lower the effective spread, the lower the 
cost to the investor.
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    Average realized spreads (another measure of trading costs) for 
options priced below $20 were $0.18 in August 1999 and $0.17 in October 
2000.\17\ Average realized spreads for larger orders (i.e., those above 
50 contracts and ineligible for automatic execution at that time) 
actually increased from $0.10 in August 1999 to $0.16 in October 2000 
(a 60% increase). This increase partially offset a fall in the average 
realized spread for smaller orders in these options, which declined 
from $0.23 in August 1999 to $0.16 in October 2000, a drop of 
approximately 30%.
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    \17\ The realized spread is a measure of trading costs, taking 
into account the informational impact of the trade. It compares 
execution prices to the bid/offer mid-point five minutes after the 
execution occurs, which provides a hypothetical measure of a trade's 
profitability to the executing broker. Effective spreads and 
realized spreads reflect the direct costs to investors of trading on 
a given options market.
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    The findings of academic economic studies that have examined the 
substantial increase in multiple listing of active options since late 
1999 are consistent with the Commission staff's findings.\18\
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    \18\ See, e.g., Battalio, Robert, Brian Hatch, and Robert 
Jennings, ``Toward a National Market System for U.S. Exchange-Listed 
Equity Options,'' Journal of Finance, forthcoming (covering June 
2000 to January 2002 and indicating that bid-ask spreads have 
declined since multiple listing of most active options) and De 
Fontnouvelle, Patrick, Raymond P.H. Fishe, and Jeffrey H. Harris, 
``The Behavior of Bid-Ask Spreads and Volume in Options Markets 
During the Competition for Listings in 1999,'' Journal of Finance, 
Vol. 58, No. 6 pp. 2437-2463 (2003) (indicating that spreads became 
significantly narrower around August 1999 when a large number of 
options moved from single to multiple listing). The results of these 
studies are consistent with other research that studied earlier 
periods. See, e.g., Mayhew, Stewart ``Competition, Market Structure, 
and Bid-Ask Spreads in Stock Option Markets,'' Journal of Finance 
v.57 n.2 (April 2002) pp. 931-958 (examining CBOE options from 1986 
to 1997 and indicating that options listed on multiple exchanges had 
narrower spreads than those listed on a single exchange) and ``The 
Effect of Multiple Trading on the Market for OTC Options,'' SEC 
(1986).
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B. Marketplace Innovations

    In addition to narrowing spreads, the expansion of multiple trading 
has led the options markets to implement market structure innovations 
designed to attract more order flow by enhancing the efficiency, 
transparency, and liquidity of their markets. Such innovations include 
increasing the automated processing of orders routed to the floor-based 
options exchanges, expanding access to exchanges' automated execution 
systems to include broker-dealer orders as well as customer orders, and 
displaying the size of trading interest in quotations. Finally, 
exchanges have implemented electronic systems that enhance intramarket 
competition by permitting market makers independently to auto-quote.
1. Expansion of Auto-Ex Systems
    In response to evolving market structures, technological advances, 
and enhanced competition among the markets, options exchanges have made 
changes to their auto-ex systems. Initially, auto-ex systems were 
designed to provide instantaneous executions for small public customer 
orders. In response to competitive pressures and a growing demand for 
quicker and more efficient executions, the options exchanges began 
increasing the maximum number of contracts eligible for execution 
through their auto-ex systems.\19\ After the start of multiple listing, 
the use of auto-ex systems has expanded significantly.
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    \19\ During the 1980s, options exchanges permitted orders in 
sizes of between five and ten options contracts to be executed 
through their auto-ex systems. See, e.g., Exchange Act Release Nos. 
21695 (Jan. 28, 1985), 50 FR 4823 (Feb. 1, 1985) (File No. SR-CBOE-
84-30) (permitting automated executions of up to five contracts); 
22015 (May 6, 1985), 50 FR 19832 (May 10, 1985) (File No. SR-CBOE-
85-14) (permitting automated executions of up to ten contracts); and 
27599 (Jan. 9, 1990), 55 FR 1751 (Jan. 18, 1990) (File No. SR-Phlx-
89-03) (permitting automated executions of up to ten contracts). PCX 
allowed automated executions of up to ten contacts in 1993. See 
Exchange Act Release No. 32703 (July 30, 1993), 58 FR 42117 (August 
6, 1993) (File No. SR-PSE-92-37).
    Over the next decade, the maximum number of options contracts 
per order permitted for automated execution steadily increased from 
ten contracts to fifty contracts. See, e.g., Exchange Act Release 
Nos. 24899 (Sept. 10, 1987), 52 FR 35012 (Sept. 16, 1987) (File No. 
SR-Amex-87-21); 28411 (Sept. 6, 1990), 55 FR 37784 (Sept. 13, 1990) 
(File Nos. SR-CBOE-89-27 and SR-CBOE-89-29); 29837 (Oct. 18, 1991), 
56 FR 55146 (Oct. 24, 1991) (File No. SR-Phlx-91-33); and 34946 
(Nov. 7, 1994), 59 FR 59265 (Nov. 16, 1994) (File No. SR-PSE-94-18); 
32906 (Sept. 15, 1993), 58 FR 49345 (Sept. 22, 1993) (File No. SR-
Phlx-92-38); 36601 (Dec. 18, 1995), 60 FR 66817 (Dec. 26, 1995) 
(File No. SR-Phlx-95-39); 41821 (Sept. 1, 1999), 64 FR 50313 (Sept. 
16, 1999) (File No. SR-CBOE-99-17); 41823 (Sept. 1, 1999), 64 FR 
49265 (Sept. 10, 1999) (File No. SR-PCX-99-04); and 42094 (Nov. 3, 
1999), 64 FR 61675 (Nov. 12, 1999) (File No. SR-Amex-99-43).
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    In 2000, all of the floor-based options exchanges simultaneously 
increased the maximum number of options contracts in an order eligible 
for automated execution from fifty to seventy-five contracts \20\ and 
quickly increased the size again to 100 contracts.\21\ In 2001, three 
of the options exchanges--Amex, Phlx, and PCX--increased their maximum 
guaranteed order size for automated execution to 250 contracts.\22\ In 
2003, Amex increased its maximum guaranteed order size for automated 
executions to 500 contracts.\23\
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    \20\ See Exchange Act Release Nos. 43516 (Nov. 3, 2000), 65 FR 
69079 (Nov. 15, 2000) (File No. SR-Amex-99-45); 43517 (Nov. 3, 
2000), 65 FR 69082 (Nov. 15, 2000) (File No. SR-CBOE-99-51); 43515 
(Nov. 3, 2000), 65 FR 69114 (Nov. 15, 2000) (File No. SR-Phlx-99-
32); and 43518 (Nov. 3, 2000), 65 FR 69111 (Nov. 15, 2000) (File No. 
SR-PCX-00-32).
    \21\ See Exchange Act Release Nos. 43887 (Jan. 25, 2001), 66 FR 
8831 (Feb. 2, 2001) (File Nos. SR-Amex-00-57 and SR-PCX-00-18); 
44008 (Feb. 27, 2001), 66 FR 13599 (March 6, 2001) (File No. SR-
CBOE-01-03); 44054 (March 8, 2001), 66 FR 15314 (March 16, 2001) 
(File No. SR-Phlx-2001-31) (permitting automated executions of up to 
100 contracts in QQQ options); and 44404 (June 11, 2001), 66 FR 
32857 (June 18, 2001) (File No. SR-Phlx-2001-51) (permitting 
automated executions of up to 100 contracts in all options).
    \22\ See Exchange Act Release Nos. 45628 (March 22, 2002), 67 FR 
15262 (March 29, 2002) (File No. SR-Amex-2001-94); 45641 (March 25, 
2002), 67 FR 15445 (April 1, 2002) (File No. SR-PCX-2001-48); 45629 
(March 22, 2002), 67 FR 15271 (March 29, 2002) (File No. SR-Phlx-
2001-89) (permitting automated executions of up to 250 contracts in 
QQQ options); and 45893 (May 8, 2002), 67 FR 34746 (May 15, 2002) 
(File No. 2002-25) (permitting automated executions of up to 250 
contracts in all options).
    \23\ See Exchange Act Release No. 47673 (April 14, 2003), 68 FR 
19242 (April 18, 2003) (File No. SR-Amex-2003-08). Amex floor 
officials have the discretion to raise the auto-ex limit to 500 
contracts on a case-by-case basis.
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    The competitive responses with respect to one of the most widely 
traded exchange-traded funds, QQQ, which

[[Page 6127]]

tracks the Nasdaq 100 Index, illustrate the fiercely competitive nature 
of the options markets since the start of multiple listing. In 2002, 
CBOE began allowing automated executions of up to 500 contracts in QQQ 
options.\24\ Amex immediately matched the CBOE's proposal.\25\ ISE soon 
announced that its Primary Market Maker in the QQQ options would 
guarantee a size of up to 2,000 contracts in the two near-term 
expiration months and up to 1,000 contracts for all other expiration 
months for customer orders in QQQ options. Amex soon matched ISE's 
move.\26\ In late 2002, Phlx matched ISE's and Amex's maximum 
guaranteed automated execution order size for QQQ options.\27\ In early 
2003, PCX matched the other exchanges.\28\
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    \24\ See Exchange Act Release No. 45676 (March 29, 2002), 67 FR 
16478 (April 5, 2002) (order approving File No. SR-CBOE-2001-70).
    \25\ See Exchange Act Release Nos. 45756 (April 15, 2002), 67 FR 
19603 (April 22, 2002) (notice of filing and immediate effectiveness 
of File No. SR-Amex-2002-29).
    \26\ See Exchange Act Release No. 45828 (April 25, 2002), 67 FR 
22140 (May 2, 2002) (File No. SR-Amex-2002-30).
    \27\ See Exchange Act Release No. 46531 (Sept. 23, 2002), 67 FR 
61370 (Sept. 30, 2002) (File No. SR-Phlx-2002-47).
    \28\ See Exchange Act Release No. 47667 (April 10, 2003), 68 FR 
19244 (April 18, 2003) (File No. SR-PCX-2003-14).
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    In addition to increasing the size of public customer orders 
eligible for automated execution, in 2001, the options exchanges began 
permitting non-market maker broker-dealer orders to be executed through 
their respective auto-ex systems.\29\
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    \29\ See Exchange Act Release Nos. 45032 (Nov. 6, 2001), 66 FR 
57145 (Nov. 14, 2001) (File No. SR-PCX-00-05); 46517 (Sept. 20, 
2002), 67 FR 61182 (Sept. 27, 2002) (File No. SR-PCX-2002-50); 46479 
(Sept. 10, 2002), 67 FR 58654 (Sept. 17, 2002) (File No. SR-Amex-
2002-57); 45758 (April 15, 2002), 67 FR 19610 (April 22, 2002) (File 
No. Phlx-2001-40); 46660 (Oct. 15, 2002), 67 FR 64951 (Oct. 22, 
2002) (File No. SR-Phlx-2002-50); 45967 (May 20, 2002), 67 FR 37888 
(May 30, 2002) (File No. SR-CBOE-2002-22); 46113 (June 25, 2002), 67 
FR 44486 (July 2, 2002) (File No. SR-CBOE-2002-35); and 46598 (Oct. 
3, 2002), 67 FR 63478 (Oct. 11, 2002) (File No. SR-CBOE-2002-56).
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2. Enhanced Automation of Trading on Floor-Based Exchanges
    The floor-based options exchanges have also increased the automated 
handling of orders on their facilities. For example, Phlx, CBOE, and 
Amex enhanced the integration of their automated execution systems with 
their order books to enable incoming orders to trade automatically with 
booked orders that establish the prevailing market.\30\ Similarly, 
several exchanges are automating the execution of orders on the book 
that lock or cross a quote generated by the exchange's auto-quote 
systems.\31\ In addition, Amex automated the allocation of contracts 
between specialist and registered options traders under certain 
circumstances where the specialist would otherwise manually allocate 
such contracts.\32\
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    \30\ Exchange Act Release Nos. 48472 (Sept. 10, 2003), 68 FR 
54513 (Sept. 13, 2003) (permits automated execution on Phlx of 
eligible inbound customer and off-floor broker-dealer limit orders 
against booked customer limit orders at the exchange's disseminated 
quote); 45244 (Jan. 7, 2002), 67 FR 1526 (Jan. 11, 2002) (allows 
certain orders entered through CBOE's order routing system to trade 
automatically against the book); and 42652 (April 7, 2000), 65 FR 
20235 (April 14, 2000) (incoming market and marketable limit orders 
bypass Amex's auto-ex system and match against orders in the book).
    \31\ See Exchange Act Release Nos. 44462 (June 21, 2001), 66 FR 
34495 (June 28, 2001) (approving CBOE proposal to allow orders on 
the book to be executed automatically where a quote generated by the 
exchange's auto-quote system is equal to or crosses the exchange's 
best bid or offer as established by a booked order); and 44468 (June 
22, 2001), 66 FR 34505 (June 28, 2001) (approving PCX pilot program 
to allow automated execution of marketable limit orders against 
market makers when the limit orders are crossed or locked by PCX's 
auto-quote system). See also File No. SR-Phlx-2003-30 (Phlx proposal 
to execute automatically limit orders on the book when the 
exchange's auto-quote (or a specialist's quote) crosses or locks the 
exchange's best market as set by an order in the book).
    \32\ Exchange Act Release No. 45974 (May 22, 2002), 67 FR 37886 
(May 30, 2002).
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3. Displaying Size in Quotes
    Displaying information about the size of options quotes is another 
recent enhancement in the options markets. Since its inception in May 
2000, the ISE displayed quotations accompanied by size within its 
market. At that time, the Options Price Reporting Authority (``OPRA'') 
did not collect from the options exchanges and disseminate to quotation 
vendors the sizes associated with options quotations. In addition, the 
floor-based options exchanges did not independently display the sizes 
of their market participants' quotations.
    In response to the increased transparency offered on ISE's 
electronic system, the floor-based exchanges began to implement 
technology to disseminate quotations with size. In addition, OPRA 
enhanced its systems to collect and disseminate quotations with size 
from the options exchanges. In 2001, each of the options exchanges 
began disseminating the size associated with their quotations through 
OPRA.\33\
---------------------------------------------------------------------------

    \33\ See Exchange Act Release Nos. 44145 (April 2, 2001), 66 FR 
18662 (April 10, 2001) and 44383 (June 2, 2001), 66 FR 30959 (June 
8, 2001); and CBOE Regulatory Circular RG 01-50 (April 17, 2001).
---------------------------------------------------------------------------

4. Automated Systems That Enhance IntraMarket Quote Competition
    ISE's electronic structure enables it to collect and disseminate 
competitive quotes from multiple market makers. Because ISE's market 
makers only trade with incoming orders when their quotes represent the 
best price,\34\ they have a strong incentive to quote aggressively. As 
a result, ISE's disseminated prices represent the best quote of any 
market maker or priced order in the ISE order book and frequently set 
or match the best bid or offer in the market.\35\
---------------------------------------------------------------------------

    \34\ See ISE Exchange Approval, infra note 52, text accompanying 
nn. 93-94.
    \35\ The Commission's Office of Economic Analysis studied ten of 
the most actively traded options issues (AOL, Citigroup, Cisco, 
Dell, IBM, Microsoft, Intel Wrap, Pfizer, Peoplesoft, and QQQ Wrap) 
for the period of June 2-6, 2003 (prior to the implementation of 
CBOE's hybrid trading system, discussed below) and found that ISE 
was at the best bid and at the best offer in these options 
significantly more frequently than any other options exchange. The 
study also found that ISE was alone at the best bid and offer 
significantly more frequently than any other exchange. ISE was at 
the inside bid 87% of the time compared to 56% of the time for CBOE, 
the next closest competitor. ISE was at the inside ask 83% of the 
time (compared with 61% for CBOE, the next most frequent). ISE was 
alone at the inside bid 12% and alone at the inside ask 11% of the 
time (compared to CBOE's 3% and 5%, CBOE was the second most 
frequent in each).
---------------------------------------------------------------------------

    Unlike the ISE, quotes on the floor-based options exchanges 
historically represented the auto-quotes of the specialists. These 
quotes, however, are considered the quotes of all market makers on the 
exchange. When orders are routed to a floor-based options exchange for 
automated execution, they generally trade at the auto-quoted price. 
Such orders are allocated to market makers in the crowd on a ``wheel,'' 
where they each take portions of an order in turn. Thus, market makers 
do not have an incentive, or even a practical ability, to improve the 
disseminated quote.
    ISE soon began to capture market share from the other options 
exchanges. In response to competition from ISE and to comply with the 
terms of a settlement agreement the floor-based options exchanges 
reached with the Commission, the floor-based exchanges introduced new 
technology to their trading platforms to enhance the speed and 
efficiency of executions on those markets.\36\ One of the more recent 
innovations is CBOE's hybrid trading platform, which it began rolling 
out in 2003. This new trading platform combines features of the open 
outcry

[[Page 6128]]

market with an electronic, competing dealer model.\37\
---------------------------------------------------------------------------

    \36\ See, e.g., ``CBOE Bets Streaming Quotes Will Cool ISE--The 
Chicago Board Options Exchange is launching a hybrid-trading system 
with streaming market-maker quotes to counter its all-electronic 
rival,'' Wall Street & Technology p. 41 (July 1, 2003). As discussed 
in Section V. E. infra, the enforcement settlement required the 
floor-based options exchanges, among other things, to amend their 
existing rules governing their automated quotation and execution 
systems to increase incentives to quote competitively.
    \37\ Exchange Act Release No. 47959 (May 30, 2003), 68 FR 34441 
(June 9, 2003).
---------------------------------------------------------------------------

    As is the case with ISE's model, CBOE's hybrid trading platform 
allows market makers and designated primary market makers (``DPM's) 
(CBOE's specialist equivalent) to submit electronically quotes that 
represent their own trading interest. In addition, floor brokers in the 
crowd may enter orders on behalf of their customers. The best bid and 
offer among submitted market maker quotes and customer orders is 
disseminated as CBOE's best bid or offer. As such, the hybrid trading 
platform greatly expands the potential sources of intraexchange quote 
competition on CBOE.\38\
---------------------------------------------------------------------------

    \38\ For options that are not yet trading on the hybrid 
platform, CBOE's disseminated quote represents, for the most part, 
only the automatically generated quotations of the DPM. Market 
makers are able to impact the CBOE quote only in open outcry or by 
inputting quotes manually. As a result, there is virtually no 
intraexchange quote competition in CBOE options that are not trading 
on the hybrid platform.
---------------------------------------------------------------------------

    Preliminary research on the first group of securities phased into 
CBOE's hybrid platform shows a dramatic narrowing of quoted and 
effective spreads in those securities on CBOE. The Commission's Office 
of Economic Analysis examined average quoted and effective spreads of 
the first 22 options classes phased into CBOE's hybrid trading platform 
and found that average quoted spreads decreased from $0.2422 over the 
20 trading days before each of the options was phased into the system, 
to $0.1929 in the 20 trading days after the options were phased in, a 
decrease of over 20%.\39\ The average effective spread for these 
securities on CBOE decreased from $0.1170 to $0.0974, a decline of 
nearly 17%. Two control samples were used to ensure that these observed 
changes were not driven by other, coincidental changes in market 
conditions'quotes on the same options on the other exchanges, and 
quotes on other CBOE options that did not switch to the hybrid 
platform. No similar decrease in quoted and effective spreads was 
observed in the control sample.
---------------------------------------------------------------------------

    \39\ Because the 22 options classes were phased in over multiple 
days between June 12 and July 11, 2003, to compare spreads 
consistently it was necessary to assign event dates from ``20 to 20 
to each of the classes. An event date of ``20 was the date 20 
trading days before an option was phased into the hybrid platform. 
An event date of 0 was the date it was phased in, and an event date 
of 20 was the date 20 trading days after a class was phased in.
---------------------------------------------------------------------------

    Other registered options exchanges have developed their own 
innovative technology platforms. For example, in May 2003, the 
Commission approved PCX's new hybrid trading platform which will 
accommodate independent quotations from three types of market 
makers.\40\ As they do today, Lead Market Makers (``LMMs'') would 
continue to provide two-sided markets throughout the trading day, while 
conducting their trading activities on the floor of the exchange. 
Remote Market Makers would be permitted to enter quotes and effect 
trades from off-site locations and to select their appointed issues. 
Floor Market Makers, which are registered market makers with basic 
obligations on the PCX options floor, would continue to trade as they 
do today and would supply independently generated quotes with size. 
Members could choose not to generate their own quote independently by 
acting as Supplemental Market Makers, which would add liquidity at the 
same price that is then being disseminated by the LMM. PCX began 
phasing in the new platform on October 6, 2003. Like the CBOE hybrid 
system, PCX's system should enhance intraexchange quote competition.
---------------------------------------------------------------------------

    \40\ See, e.g., Exchange Act Release No. 47838 (May 13, 2003), 
68 FR 27129 (May 19, 2003) (order approving PCX's hybrid trading 
platform for options). See also SR-Phlx-2003-59 (proposal to 
establish a new Phlx electronic trading platform that would permit 
exchange members to submit streaming electronic option quotations 
via an electronic interface with Phlx's Automated Options Market 
System); and SR-Amex-2003-89 (proposing to establish a new trading 
system that would permit registered options traders to auto-quote 
independent of the specialist's quote).
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C. Payment for Order Flow, Specialist Guarantees, and Internalization

    While encouraging innovations by options exchanges, multiple 
listing also resulted in competition among markets in the form of 
payment for order flow, enhanced specialist participation rights, and 
internalization. Unlike the forms of competition described above, which 
clearly benefit customers, these arrangements principally benefit 
intermediaries in the first instance, which may or may not pass on 
those benefits to their customers. The broad proliferation of these 
arrangements in the options markets followed widespread multiple 
listing of the most active options in 1999.\41\
---------------------------------------------------------------------------

    \41\ In its December 2000 study, the SEC staff examined the rise 
of payment for order flow arrangements in the options markets and 
found that the percentage of retail customer options orders that 
were paid for under a payment for order flow arrangement soared from 
August 1999, when virtually no orders were subject to such 
arrangements, to August 2000, when nearly 78% of such orders were. 
See SEC Staff Special Study, supra note 13. The staff found that 
cash payments were the most common form of payment for order flow in 
the options markets, although other inducements also were noted. For 
instance, some firms routed customer options orders to affiliated 
specialists. Firms that route order flow to an affiliated specialist 
are able to benefit through increased profits generated by that 
specialist, which does not have to pay cash for its affiliates' 
order flow. Other firms have entered into reciprocal order flow 
arrangements, under which each agrees to route customer order flow 
to the other.
---------------------------------------------------------------------------

    When most options were traded on only one market, order entry firms 
had no choice where they routed their customers' orders for execution. 
As the number of trading venues for those options increased, however, 
order entry firms could choose between these venues in executing 
customers' orders. Indeed, where the same option trades on multiple 
venues, a broker-dealer's best execution obligation requires regular 
and rigorous review of execution quality. As a result, options markets 
and the market participants that trade there have sought to make their 
markets more attractive to order entry firms whose order flow they are 
attempting to attract. As discussed above, market participants have 
adapted to greater competition by tightening spreads and the exchanges 
themselves have done so by enhancing services.
    At the same time, the specialists and market makers on the options 
markets have begun competing for order flow by offering cash or non-
cash inducements, known as payment for order flow, to firms to send 
their orders to a particular exchange.\42\ Another inducement exchanges 
use to attract order flow is permitting firms to trade with--or 
internalize--their own customers' orders. Both practices are a way to 
share the profit a dealer makes on a trade with the intermediary 
representing a customer order.
---------------------------------------------------------------------------

    \42\ The Commission has defined 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 to any 
broker or dealer, national securities exchange, registered 
securities association, or exchange member for execution, 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.'' 17 CFR 240.10b-10(d)(9). In the Commission staff's 
December 2000 study the staff concluded that while payment for order 
flow clearly impacted broker-dealers' order routing decisions, such 
arrangements had not, at that point, had a material adverse impact 
on effective spreads. The staff concluded that further monitoring of 
the arrangements was warranted. See SEC Staff Special Study, supra 
note 13.

---------------------------------------------------------------------------

[[Page 6129]]

1. Payment for Order Flow Arrangements
    Under a typical payment for order flow arrangement, a specialist 
offers an order entry firm cash or other economic inducement to route 
its customer orders to that specialist's exchange because the 
specialist knows it will be able to trade with a portion of all 
incoming orders, including those from firms with which it has payment 
for order flow arrangements. The more dominant the specialist is on a 
particular exchange (i.e., the fewer market makers with which it must 
compete for order flow), the more order flow it will trade with and the 
more it will be able to pay for order flow. Consequently, specialists 
benefit from exchange rules that guarantee the specialist the ability 
to trade with a certain percentage of the order flow for which they 
pay. Such ``specialist guarantees'' are discussed further below.
    A specialist on an exchange where its role is less dominant (i.e., 
where market makers in the crowd successfully compete with the 
specialist to trade with incoming orders), cannot, on its own, pay as 
much for order flow. For this reason, to compete, exchanges where there 
is substantial competition among market makers were the first to impose 
fees upon their members to fund payment for order flow collectively. 
Such exchange fees were designed to ensure that market makers that may 
trade with customers on the exchange contribute to the cost of 
attracting that order flow. Currently, all of the options exchanges 
have such ``exchange-sponsored payment for order flow programs'' in 
place.\43\
---------------------------------------------------------------------------

    \43\ Exchange Act Release Nos. 48053 (June 17, 2003), 68 FR 
37880 (June 25, 2003) (SR-Amex-2003-50); 47948 (May 30, 2003), 68 FR 
33749 (June 5, 2003) (SR-CBOE-2003-19); 43833 (Jan. 10, 2001), 66 FR 
7822 (Jan. 25, 2001) (SR-ISE-00-10); 43290 (Sept. 13, 2000), 65 FR 
57213 (Sept. 21, 2000) (SR-PCX-00-30); and 47090 (Dec. 23, 2002), 68 
FR 141 (Jan. 2, 2003) (SR-Phlx-2002-75).
---------------------------------------------------------------------------

    Section 19 of the Act and Rule 19b-4 adopted under the Act permit 
such payment for order flow arrangements to become effective upon 
filing and therefore do not require prior Commission approval because 
the arrangements impose fees that apply only to members of the 
exchange.\44\ In soliciting public comment on one such proposal, the 
Commission noted that while it is concerned about payment for order 
flow generally, the Act provides a self-regulatory organization 
(``SRO'') wide latitude in imposing fees on its members.\45\
---------------------------------------------------------------------------

    \44\ See Exchange Act Section 19(b)(3)(A)(ii) (15 U.S.C. 
78s((b)(3)(A)(ii)) and Rule 19b-4(f)(2) (17 CFR 240. 19b-4(f)(2)). 
Within 60 days of filing of a proposal filed under Exchange Act 
Section 19(b)(3)(A), the Commission may summarily abrogate the 
proposal and require that the proposal be refiled (if at all) under 
Section 19(b)(1) of the Act, in which case the Commission must 
approve it prior to it becoming effective. See Exchange Act Section 
19(b)(3)(C), 15 U.S.C. 78s(b)(3)(C).
    \45\ See Exchange Act Release No. 43290 (Sept. 13, 2000), 65 FR 
57213, 57214-215 (Sept. 21, 2000) (notice of filing and immediate 
effectiveness of SR-PCX-00-30); see also Exchange Act Release Nos. 
43112 (August 3, 2000), 65 FR 49040 (August 10, 2000) (notice of 
filing and immediate effectiveness of SR-CBOE-00-28) and 43833, 66 
FR at 7825 (approving SR-ISE-00-10, imposing such fees is a 
legitimate business decision of the exchange).
---------------------------------------------------------------------------

2. Specialist Guarantees
    All five options exchanges currently have rules that guarantee a 
specialist a proportion of each order when its quote is equal to the 
best price on the exchange.\46\ These so-called ``specialist 
guarantees'' reward market making firms willing to perform the 
obligations of a specialist by ensuring that they will be able to 
interact as principal with a certain percentage of incoming orders. 
Specialist guarantees are special allocation provisions that differ 
from the general rules of the exchanges that assign executions based on 
priority, parity, and precedence.\47\ Specialist guarantees are 
intended to attract and retain well-capitalized firms that are 
responsible under exchange rules for assuring fair and orderly markets 
and fulfilling other responsibilities that enhance the exchange.
---------------------------------------------------------------------------

    \46\ The term specialist is used in this release to include, in 
addition to specialists, DPMs, LMMs and PMMs.
    \47\ Each exchange has rules of priority, parity, and precedence 
that govern the order in which bids and offers participate in a 
transaction. For a discussion of exchanges' execution priority rules 
see Exchange Act Release No. 43100 (July 31, 2000), 65 FR 48778, 
48785 (August 9, 2000) (File No. SR-Phlx-00-01, proposing to amend 
Phlx's enhanced specialist participation provisions) [``Notice of 
Phlx 80/20 Proposal''].
---------------------------------------------------------------------------

    The Commission has closely scrutinized exchange rule proposals to 
adopt or amend a specialist guarantee where the percentage of 
specialist participation would rise to a level that could have a 
material adverse impact on quote competition within a particular 
exchange. For instance, in 2000 Phlx filed a proposal with the 
Commission to raise its specialist participation to 80% for certain 
options orders.\48\ This specialist guarantee may have helped Phlx 
compete with other exchanges because its specialists, all things being 
equal, may have been able to pay more to attract order flow than other 
exchanges' specialists that received a lesser guarantee.
---------------------------------------------------------------------------

    \48\ The 80% provision would have applied to orders for the top 
100 options based on volume allocated to a Phlx specialist after 
January 1, 1997 (i.e., new allocations). Although the proposal had a 
number of provisions other than the 80% allocation provision, the 
Commission expressed particular concern with that provision. Id., 65 
FR at 48784.
---------------------------------------------------------------------------

    The Commission was concerned, however, that the Phlx proposal could 
have significantly discouraged price competition on that market by 
``locking up'' such a large proportion of each order that it would have 
hindered market makers in the crowd from competing with the specialist. 
The Commission believed that, over the long-term, the decrease in 
intramarket competition could have widened spreads and diminished the 
quality of prices available to investors.\49\ Moreover, the Commission 
was concerned that, if it approved the Phlx proposal, other exchanges 
could have proposed similar specialist guarantees to remain 
competitive,\50\ thereby permanently undermining intramarket 
competition on each exchange. Phlx ultimately withdrew the proposal.
---------------------------------------------------------------------------

    \49\ Id.
    \50\ Id. at 48789.
---------------------------------------------------------------------------

3. Internalization
    Internalization opportunities are another form of economic 
inducement that exchanges use to attract order flow. One such 
arrangement is referred to as a facilitation guarantee, whereby an 
upstairs firm that brings a large customer order to the exchange 
(typically at least 50 contracts) may trade as principal with a certain 
percentage (up to 40%) of the contracts in that order under certain 
circumstances.\51\ Exchanges use facilitation guarantees to induce 
upstairs firms to execute their customer orders on the exchange by 
limiting the degree to which the exchange crowd may interact with those 
orders. Like specialist guarantees, facilitation guarantees modify 
general exchange rules that assign executions based on priority, 
parity, and precedence, and like specialist guarantees and payment for 
order flow, exchange rules providing facilitation guarantees raise 
competitive and regulatory issues.
---------------------------------------------------------------------------

    \51\ Of course, if no other market participant on the exchange 
is willing to trade with a particular order, the upstairs firm may 
internalize the entire order.
---------------------------------------------------------------------------

    Prior to widespread multiple listing, exchange rules gave crowd 
participants precedence in trading with all orders. As a result, an 
upstairs firm could not trade with any portion of its customer's order 
with which crowd members wanted to trade. After August 1999, however, 
as the options markets began to list multiply the most actively traded 
options, competition among exchanges for incoming orders intensified, 
and the options exchanges adopted rules that provided upstairs firms 
more

[[Page 6130]]

opportunities to participate in the execution of certain customer 
orders they bring to the exchanges. For example, ISE adopted a rule in 
February 2000 that permits upstairs firms to interact as principal with 
up to 40% of orders of 50 contracts or more that the firm presents to 
the exchange after an auction and other conditions are satisfied.\52\
---------------------------------------------------------------------------

    \52\ In the Matter of the Application of the International 
Securities Exchange, LLC For Registration as a National Securities 
Exchange, Release No. 42455 (Feb. 24, 2000) (``ISE Exchange 
Approval''). When an order is entered into the facilitation 
mechanism, ISE sends a facilitation broadcast to crowd participants 
informing them of the proposed transaction. The broadcast contains 
information on the terms and conditions of the order, including the 
facilitation price, and the crowd is given ten seconds to respond. 
The upstairs firm entering the facilitation order will be allocated 
40% of the original size of the facilitation order, but only after 
better-priced orders, quotes, and public customer orders at the 
facilitation price are executed. In approving the ISE's rule, the 
Commission noted: ``It is difficult to assess the precise level at 
which guarantees may begin to erode competitive market maker 
participation and potential price competition within a given market. 
In the future, after the Commission has studied the impact of 
guarantees, the Commission may need to reassess the level of these 
guarantees. For the immediate term, the Commission believes that 
forty percent is not clearly inconsistent with the statutory 
standards of competition and free and open markets.'' Id at text 
accompanying nn. 118-119.
---------------------------------------------------------------------------

    After the Commission approved ISE's proposal, each of the other 
options exchanges adopted similar rules.\53\ To qualify for the 
guarantee, all require the facilitation orders to be at least 50 
contracts, and the maximum guarantee right is 40% of the contracts in 
those orders. Moreover, if both a specialist and an upstairs firm would 
be entitled to a guarantee with respect to the same trade, the combined 
guarantee of the two firms may not exceed 40% of the contracts to be 
traded, thereby allowing the trading crowd to compete for at least 60% 
of any such transaction.\54\ Unlike internalization in the over-the-
counter equity market, the options exchanges' rules permit a firm to 
trade with its own customer's order only after an auction in which 
other members of that market have an opportunity to participate in the 
trade at the proposed price or an improved price. This auction provides 
some assurance that the customer's order is executed at the best price 
any member in that market is willing to offer.
---------------------------------------------------------------------------

    \53\ See Exchange Act Release Nos. 42835 (May 26, 2000), 65 FR 
35683 (June 5, 2000); 42848 (May 26, 2000), 65 FR 36206 (June 7, 
2000); 42894 (June 2, 2000), 65 FR 36850 (June 12, 2000); and 47819 
(May 8, 2003), 68 FR 25924 (May 14, 2003) (orders approving, 
respectively, File Nos. SR-CBOE-99-10; SR-PCX-99-18; SR-Amex-99-36; 
and SR-Phlx-2002-17).
    \54\ See Notice of Phlx 80/20 proposal, supra note 47, 65 FR at 
48786.
---------------------------------------------------------------------------

IV. Concerns With Payment for Order Flow, Specialist Guarantees, and 
Internalization

    While payment for order flow, specialist guarantees, and 
internalization are responses to a more competitive marketplace, 
critics assert that these practices are detrimental to the options 
markets because they can decrease quote competition, interfere with a 
broker-dealer's best execution obligation, and can conflict with a 
market's role as an SRO.\55\
---------------------------------------------------------------------------

    \55\ For a discussion of the concerns with payment for order 
flow, see SEC Staff Special Study, supra note 13. See also Phlx 
Petition, infra note 95 and Susquehanna Petition, infra note 96.
---------------------------------------------------------------------------

A. Quote Competition

    One concern frequently raised about payment for order flow 
arrangements is that they may diminish quote competition. Specifically, 
the concern is that a market maker or specialist that receives order 
flow because of a payment for order flow arrangement will have less 
need to quote aggressively to attract order flow, and as a result, 
spreads may be wider than they otherwise would be. A related argument 
is that payment for order flow arrangements raise costs for market 
makers and, as a result, the market makers may widen spreads to offset 
the costs of paying for order flow. Rules or practices that permit or 
encourage internalization may also reduce intramarket price competition 
and, therefore, cause spreads to widen.\56\ In addition, because an 
upstairs firm can choose among several exchanges to send its order 
flow, market makers may be concerned that if they quote too 
aggressively, the upstairs firm facilitating its customers' orders may 
take those orders to another, less competitive, exchange where the 
upstairs firm could internalize a greater portion of those orders, 
possibly at prices that are inferior from the customers' perspective. 
The Commission requests comment on these concerns.
    Question 1.To what extent, if any, does payment for order flow in 
the options markets affect a specialist's or market maker's incentive 
to quote aggressively?
---------------------------------------------------------------------------

    \56\ See Exchange Act Release No. 43084 (July 28, 2000) 65 FR 
48406, 48419 (August 8, 2000) (proposing Exchange Rules 11Ac1-5 and 
11Ac1-6).
---------------------------------------------------------------------------

    Question 2. If commenters believe that payment for order flow 
diminishes a specialist's or market maker's incentives to quote 
aggressively, why have spreads narrowed over the past few years while 
payment for order flow increased?
    Question 3. Where multiple market participants can quote 
independently and incoming orders are allocated to the market 
participant that sets the best quote, are market participants more or 
less likely to enter payment for order flow arrangements than those on 
markets with less intramarket quote competition?
    Question 4. Do current exchange rules guaranteeing specialists a 
certain portion of orders affect quote competition? To what extent is 
intramarket quote competition preserved by requiring that non-
specialist market makers be permitted to compete for at least 60% of an 
order without bettering the specialist's quote? Is the harm to quote 
competition, if any, decreased on those markets that permit market 
makers to auto-quote?
    Question 5. Is a market maker's incentive to quote aggressively 
impacted by the percentage of orders that an upstairs firm can 
internalize? For example, all things being equal, is a market maker 
less likely to quote aggressively if exchange rules or customs permit 
an upstairs firm to internalize a substantial portion of each order 
that it brings to the exchange?

B. Best Execution

    With respect to equity securities, the Commission has stated that a 
broker does not necessarily violate its duty of best execution by 
receiving payment for order flow (or internalizing its agency orders), 
but the duty also is not necessarily satisfied by routing orders to a 
market center that merely guarantees an execution at the NBBO.\57\ 
Nevertheless, concerns have been raised that a broker that routes its 
customer orders to a particular market with which it has a payment for 
order flow arrangement may not be meeting its best execution 
obligations with respect to those orders.\58\ Critics of payment for 
order flow arrangements assert that a broker that routes its customers' 
orders pursuant to such an arrangement is

[[Page 6131]]

more likely to be doing so to further its own self interest rather than 
the interests of its customers.\59\
---------------------------------------------------------------------------

    \57\ Exchange Act Release No. 42450 (Feb. 23, 2000), 65 FR 
10577, 10584 [``Fragmentation Release'']. A broker must take price 
(including opportunities for price improvement) into consideration 
in determining where to route its orders for execution, but price is 
not the only criteria that a broker may consider. It may also 
consider factors such as the trading characteristics of the security 
involved and the cost and difficulty of obtaining an execution in a 
particular market center, among other factors.
    \58\ The duty of best execution requires a broker to seek the 
most favorable terms reasonably available under the circumstances 
for a customer's transaction. See, e.g., Exchange Act Release Nos. 
43084, 65 FR at 48408 and 37619A (Sept. 6, 1996), 61 FR 48290, 48322 
at text accompanying n. 349 (Sept. 12, 1996) (adopting Rule 11Ac1-4 
and amending Rule 11Ac1-1 under the Act, also known as the Order 
Handling Rules).
    \59\ See, e.g., letter to Harvey L. Pitt, Chairman, SEC, from 
William J. Brodsky, Chairman & CEO, CBOE, (Feb. 10, 2003) wherein 
CBOE stated: ``P[ayment] F[or] O[rder] F[low] can induce broker-
dealers to decide to maximize firm profits by directing their orders 
to those markets paying the most for those orders.''
---------------------------------------------------------------------------

    Facilitation guarantees could also raise best execution concerns. 
Where a firm can profit by internalizing its customers' orders, it has 
an incentive to take those orders to an exchange that permits it, by 
rule or practice, to internalize the largest portion of its customers' 
orders. In the order approving ISE's exchange application, the 
Commission stated that a broker-dealer that withdraws ``a facilitated 
order that may be price improved simply to avoid executing the order at 
the superior price is a violation of a broker's duty of best 
execution.'' \60\ The Commission acknowledged, however, that the 
intermarket nature of such conduct might make it difficult for any one 
market to detect and deter such abusive trading behavior. Nevertheless, 
the Commission stated that it expects the options markets to work 
together through the Intermarket Surveillance Group to develop methods 
and procedures to monitor their members' trading on other markets for 
possible best execution violations.\61\
---------------------------------------------------------------------------

    \60\ ISE Exchange Approval, supra note at text accompanying n. 
118.
    \61\ Id. at n. 118.
---------------------------------------------------------------------------

    Question 6. Do customer orders that are routed pursuant to payment 
for order flow arrangements ever receive less favorable executions than 
orders not subject to such arrangements? To what extent do exchanges' 
rules requiring that members avoid trading through better prices on 
other exchanges ensure that any order, regardless of the reason for its 
being routed to a particular exchange, receives at least the best 
published quotation price?
    Some may argue that specialists in the options markets establish 
the prices and sizes of their quotes based in part on the assumption 
that their counterparties will be other professional traders. The 
desirability of trading with uninformed order flow due to the lower 
risks of trading with non-professionals should translate into those 
orders, on average, receiving better prices than the specialist's 
quote.\62\ Under this argument, specialists may use payment for order 
flow as an indirect way of providing a better execution to uninformed 
or non-professional orders.
---------------------------------------------------------------------------

    \62\ Non-professional or uninformed traders may be less likely 
to understand the ``true'' value of a security and therefore may be 
willing to pay more for it or sell it for less than would a 
professional trader. For a discussion of informed and uninformed 
traders and payment for order flow, see Allen Ferrell, A Proposal 
for Solving Payment for Order Flow, 74 S. Cal. L. Rev. 1027, 1078-80 
(May 2001).
---------------------------------------------------------------------------

    Question 7. Do market makers establish the price and size of their 
public quote based on the assumption that they may trade with an 
informed professional, which involves more risk than trading with an 
uninformed non-professional?
    Question 8. If commenters agree that public quotes are based on the 
assumption that the market maker may trade with a professional, are 
such quotes wider than they would be if market makers only received 
uninformed, non-professional orders?
    Question 9. Are market makers willing to trade with non-
professional orders at prices better than their quote?
    Question 10. If the Commission were to eliminate payment for order 
flow would non-professional orders get better prices?
    Question 11. Do customer orders that are internalized in whole or 
in part on an exchange receive less favorable executions than orders 
that are not internalized? If so, why?
    Question 12. Do exchange rules requiring that an auction occur 
prior to a trade ensure that internalized orders are executed at the 
best available price?

C. Conflicts Between the Roles of Market and SRO

    An exchange is keenly interested in maximizing the order flow sent 
to its market because much of the revenue the exchange earns come from 
those orders. At the same time an exchange has an obligation to enforce 
its members' best execution obligations. Consequently, an SRO has a 
significant conflict in assessing whether an order sent to its market 
would have received a better execution on another market. Payment for 
order flow and internalization further heighten best execution and 
other regulatory concerns because of the conflict that a broker faces 
between its interests and those of its customer. An SRO that too 
closely scrutinizes whether its members are meeting their best 
execution obligations could risk driving the members to competing 
exchanges with less stringent enforcement procedures.
    Exchange-sponsored payment for order flow arrangements raise the 
particular issue of whether an SRO, which regulates its member broker-
dealers, can effectively carry out its regulatory obligations with 
respect to best execution enforcement when it also requires its market 
makers to pay fees which, by their nature, are to be used solely to pay 
firms to send orders to the exchange.
    Question 13. Is an SRO's enforcement of its members' best execution 
obligation affected by the SRO's interest in attracting and retaining 
order flow from those same members?
    Question 14. To what extent do payment for order flow practices 
generally, or exchange-sponsored payment for order flow specifically, 
exacerbate the conflict an SRO has in carrying out its obligation to 
enforce its members' best execution obligation?
    Question 15. Does exchange-sponsored payment for order flow affect 
specialists' or market makers' incentives to quote aggressively 
differently than other types of payment for order flow? If so, in what 
respects?
    Question 16. What safeguards, if any, should an options exchange 
have in place to ensure that it can carry out its regulatory 
responsibilities with respect to those of its members that accept 
payment for order flow or internalize trades? For example, would an 
independent SRO to oversee how brokers meet their best execution 
obligations be feasible and desirable?

V. Regulatory Initiatives

    Traditionally, the Commission has not used restrictions on payment 
for order flow as a means to address concerns that the practice may 
raise. Instead, the Commission and the markets have taken steps to 
improve market transparency and price competition, which, in turn, are 
designed to address many of these concerns. As discussed below, these 
steps include implementing Exchange Act Rule 11Ac1-6, converting to 
decimal pricing, implementing an intermarket linkage, applying the 
Quote Rule to options, and removing certain barriers to transparency 
and competition as a result of the enforcement settlement between the 
Commission and the floor-based options exchanges.

A. Exchange Act Rule 11Ac1-6

    Rule 11Ac1-6, adopted in November 2000, requires broker-dealers to 
publish quarterly reports detailing where they route their customer 
orders for execution and the relationship the broker-dealer has with 
the venues to which it routes those orders, including any profit-
sharing or payment for order flow arrangements the broker-dealer may 
have with those venues.\63\ This rule

[[Page 6132]]

applies to transactions in options as well as those in equity 
securities. These quarterly reports provide investors with information 
about possible motivations a broker-dealer may have in routing its 
customers' orders to a particular venue. Rule 11Ac1-6 is limited, 
however, in that it does not provide information on the execution 
quality that a market center offers once it receives an order. That 
information is required for equity securities, but currently not for 
options, by Exchange Act Rule 11Ac1-5, which the Commission adopted at 
the same time as Rule 11Ac1-6.
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    \63\ 17 CFR 240.11Ac1-6 (b)(1)(ii)-(iii). Exchange Act Release 
No. 43590 (Nov. 17, 2000), 65 FR 75413 (Dec. 1, 2000).
---------------------------------------------------------------------------

    Rule 11Ac1-5 requires each equity market center, including each 
exchange, to publish monthly reports detailing the execution quality 
that the market center provides for equity orders that are routed to it 
for execution. Rule 11Ac1-5 reports allow market participants to 
evaluate, among other things, which markets have the lowest spreads, 
which execute orders the quickest, and which are the most likely to 
price improve orders or to execute orders at prices inferior to the 
prevailing best bid or offer.
    A recent study of NYSE-listed securities using Rule 11Ac1-5 reports 
found that ``reports based on SEC Rule 11Ac1-5 appear to have value 
beyond public trade and quote information available elsewhere.'' \64\ 
The researchers found that the value of the reports ``qualifies 
industry complaints about the high cost of producing this data, because 
the additional price competition should benefit all market 
participants.'' The study further concluded that ``the Securities and 
Exchange Commission's emphasis on disclosure as a means of affecting 
public policy can produce beneficial effects for many market 
participants, at least in the case of equity trading. It appears that 
publishing standardized execution quality statistics encourages 
(coerces) brokers to consider these statistics in their routing 
decisions.'' The authors found that although ``brokers appear to use 
other, publicly available data for routing decisions prior to the SEC's 
enactment of the rule, the reliance on the `non-official' statistics 
decreases after Rule 11Ac1-5 becomes effective.''
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    \64\ Boehmer, Ekkehart, Robert Jennings, and Li Wei, Public 
Disclosure and Private Decisions: The Case of Equity Market 
Execution Quality (August 31, 2003 Draft), available at http://www.nyse.com. Wei is from the NYSE's Research Division. Boehmer was 
a Director of Research at the NYSE while the research for the study 
was being completed. The authors studied order-routing behavior for 
NYSE-listed stocks from June 2001 to February 2003 and found that 
market share was significantly negatively related to effective 
spreads and execution speed. They determined that this fact was 
consistent with the argument that brokers use information in Rule 
11Ac1-5 reports to make order routing decisions. Based on the 
authors' estimates, a one-cent increase in effective spreads reduces 
monthly order flow by 522,060 shares for each stock traded. In 
addition, a one-second increase in execution speed resulted in a 
loss of 89,760 shares per stock. Id. at 17.
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    When it adopted Rule 11Ac1-5 and Rule 11Ac1-6, the Commission 
considered but decided not to apply Rule 11Ac1-5 to the options 
markets, stating:

    The Commission continues to believe that there is a need for 
improved disclosure of execution quality in the options markets, 
particularly now that there is widespread trading of options on 
multiple exchanges and expanding payment for options order flow. 
Nevertheless, potentially difficult issues would have to be 
addressed before options could be included within Rule 11Ac1-5. For 
example, a consolidated BBO is not, at this time, calculated and 
disseminated for options trading. A consolidated BBO is an essential 
element for nearly every statistical measure in the Rule, such as 
calculating price improvement and classifying types of limit orders 
(e.g., inside-the-quote and at-the-quote limit orders). Although 
each exchange potentially could calculate its own consolidated BBO, 
the calculations might vary at times and fail to provide a uniform 
basis for comparable statistics. In addition, categorization of 
orders on a security-by-security basis would be much less practical 
for the options markets, where there may be hundreds of series of 
options for one underlying security.\65\
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    \65\ Exchange Act Release No. 43590 (Nov. 17, 2000), 65 FR 75413 
(Dec. 1, 2000).

    In the SEC staff study discussed above,\66\ the staff made the 
following observations regarding market quality information available 
to broker-dealers in the options markets:
---------------------------------------------------------------------------

    \66\ See supra notes 13-17 and accompanying text.

     Broker-dealers do not have adequate market 
execution quality information to compare reliably the quality of 
executions between specialist firms.
     The options exchanges are developing 
execution quality reports, but these reports may not enable broker-
dealers that route customer orders adequately to compare execution 
quality on different options exchanges because each report uses 
different measures and methodologies to calculate execution quality.
     An NBBO would facilitate the creation of 
uniform measures of execution quality.
     Independent execution quality vendors have 
been unable to develop reliable execution quality reports for order 
routing firms because the exchanges have not provided them with 
adequate execution data.

    Since the study was conducted, OPRA, which transmits quotations and 
trade reports from the options markets to vendors for dissemination to 
the public, has developed a consolidated NBBO data feed for the options 
markets that is available to vendors.\67\ The NBBO that OPRA 
disseminates is the highest priced bid and the lowest priced offer 
quoted at the time on any of the five registered options exchanges.\68\ 
The minimum price increment for purposes of the NBBO is no less than 
$0.05, and, absent a change in the NBBO, the minimum size increment for 
purposes of the NBBO is no fewer than 10 contracts.\69\
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    \67\ Exchange Act Release Nos. 47231 (Jan. 22, 2003), 68 FR 4258 
(Jan. 28, 2003) (order permanently approving OPRA's BBO proposal); 
and 46992 (Dec. 13, 2002), 67 FR 78031 (Dec. 20, 2002) (approving 
OPRA's BBO proposal for 120 days).
    \68\ If the same best-priced bid or offer is quoted on more than 
one exchange, the exchange that is quoting at that price for the 
largest number of options contracts will be identified by OPRA as 
the market that is quoting the best bid or offer. If the same best 
bid or offer for the same number of options contracts is quoted on 
more than one exchange, the exchange that was first in time to quote 
that bid or offer for that number of contracts will be identified as 
the market with the BBO.
    \69\ Markets may, consistent with their own exchange rules, 
disseminate bids and offers that improve the NBBO by less than 
$0.05, or that increase the size at a given quote by fewer than ten 
contracts. Such improvements, however, would not be reflected in the 
OPRA NBBO. As discussed further below, all of the registered options 
exchanges currently set the minimum quotation increment at $0.05 for 
option issues quoted under $3 a contract and at $0.10 for option 
issues quoted at $3 and greater. As a result, currently, no exchange 
member may quote an increment through one of the registered options 
exchanges that is less than $0.05. Accordingly, OPRA's NBBO reflects 
the best-priced quotations on the registered options exchanges.
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    Below, the Commission seeks comments on whether it should extend 
Rule 11Ac1-5 to the options markets.

B. Decimals

    On January 28, 2000, the Commission ordered the SROs to convert 
from fractional quotes to quotes in decimals.\70\ The conversion from 
fractions to decimals for quotations in all equity securities and 
options was successfully completed on April 9, 2001.\71\ As a result, 
the minimum quoting increment for equity securities narrowed from \1/
16\th of a dollar ($0.0625) to a penny ($0.01). The minimum quoting 
increment for option issues quoted under $3.00 a contract was set at 
$0.05 (down from \1/16\th or $0.0625) and for options issues quoted at 
$3.00 and greater it was set at $0.10 (down from \1/8\th or $0.125). 
Research conducted with respect to the equities markets supports the 
conclusion that the move to decimal pricing has contributed to a 
substantial decrease in spreads in the equities markets.\72\ The

[[Page 6133]]

move to decimal pricing in the equities markets, and, in particular, 
the resulting narrowing of spreads, has been cited as one of the 
factors that has led to a decrease in the use of payment for order flow 
with respect to equity securities.\73\
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    \70\ Exchange Act Release No. 42360 (Jan. 28, 2000), 65 FR 5003 
(Feb. 2, 2000).
    \71\ Exchange Act Release No. 44568 (July 18, 2001), 66 FR 38390 
(July 24, 2001).
    \72\ See, e.g., The Impact of Decimalization on the Nasdaq Stock 
Market, Final Report to the SEC Prepared By Nasdaq Economic Research 
and Decimalization of Trading on the New York Stock Exchange: A 
Report to the Securities and Exchange Commission (Sept. 7, 2001). 
See also Hendrik Bessembinder, ``Trade Execution Costs and Market 
Quality after Decimalization,'' Journal of Financial and 
Quantitative Analysis, forthcoming (finding that quoted and 
effective spreads declined substantially on Nasdaq and NYSE after 
decimalization).
    \73\ See ONLINE TRADING In Slow Times, Net Brokers Look For New 
Revenue, Investor's Business Daily, Section A, p.5 (August 3, 2001): 
``Under decimals, the smallest spread between the bid and offer 
price for a stock is now just a penny. Prior to the Nasdaq's switch 
to decimals in April, spreads were at least 1/16, or .0625, of a 
dollar. That smaller spread is eating into the profit of market-
makers like Knight Trading Group Inc. That's forced them to cut back 
on a practice called payment for order flow. In return for a 
commitment to send Knight much of their customers' orders, Knight 
has been paying brokerages up to a couple of dollars on each trade. 
Now that they're struggling to remain profitable, market-makers 
can't afford to pay out as much.'' See also comments of Bernard L. 
Madoff, Bernard L. Madoff Investment Securities LLC, at SEC Market 
Structure Hearing, October 29, 2002: ``I remember everybody saying 
ban payment for order flow. They're still saying ban payment for 
order flow. We don't even pay for order flow any longer, although 
we're considering going back to paying for order flow. [A]ll of 
these things are constantly resurfac[ing].''
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    Research is more limited, however, on the impact on spreads of the 
shift from quoting in fractions to quoting in decimals (and any 
resulting impact the shift might have had on payment for order flow) in 
the options markets.\74\ While the Commission is not aware of any 
comprehensive studies showing how narrower spreads might impact payment 
for order flow in the options markets, experience in the equities 
markets suggests that, as the amount of profit a dealer can make from 
trading the spread declines, so too does the amount of money that 
dealer is willing to pay for attracting the orders with which it 
interacts.
---------------------------------------------------------------------------

    \74\ One industry study suggests that quoted and effective 
spreads for options decreased from the period before decimals to the 
period after decimal implementation. Report on the Impact of Decimal 
Pricing, prepared by CBOE (Sept. 10, 2001). CBOE studied certain 
options on securities listed on NYSE, Nasdaq and AMEX and found that 
quoted and effective spreads decreased from the pre-decimal to the 
post decimal period. CBOE discounted the results, however, given 
that spreads for a control group of securities that had shifted to 
decimals prior to the study period also declined over the period. 
CBOE further stated that the lack of a significant decline in 
spreads was expected given that the change in minimum quoting 
increments in the options markets (i.e., from $0.0625 to $0.05 and 
from $0.125 to $0.10, depending on the price of the option) was much 
less dramatic than the change in the equity markets where the 
minimum quoting increment declined from $0.0625 to $0.01.
---------------------------------------------------------------------------

    It is conceivable that the same result could occur in the options 
markets if options were quoted in one-cent increments. In other words, 
widespread payment for order flow may suggest that current pricing in 
the options markets is inefficient. If payment for order flow is a 
symptom of inefficient pricing in the options markets, removing the 
five-cent and ten-cent minimum price increments in those markets might 
allow the markets to price options contracts more accurately, which 
could result in a narrowing of spreads. If spreads narrowed, each 
transaction would be worth less to market participants that profit from 
those spreads and, as a result, they would be less likely to pay to 
attract orders or else they would be willing to pay less to attract 
them. At the same time, however, penny pricing in the options markets 
could greatly increase quote traffic, which could diminish the quality 
and timeliness of options quotation information. Below, the Commission 
seeks comments on how penny pricing in the options markets could impact 
payment for order flow.

C. Intermarket Linkage

    In early 2003, the options exchanges began sending orders through a 
linkage designed to facilitate the routing of orders between 
exchanges.\75\ The intermarket linkage is based on the national market 
system principle that brokers should have the ability to reach easily a 
better price in another market to encourage efficient pricing and best 
execution of customer orders.\76\ The linkage plan requires exchanges 
to avoid executing trades at prices inferior to the best available 
price (called a ``trade-through'').\77\
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    \75\ On October 19, 1999, the Commission directed the options 
exchanges to file a national market system plan for linking the 
options markets. Exchange Act Release No. 42029 (Oct. 19, 1999), 64 
FR 57674 (Oct. 26, 1999). The options exchanges submitted multiple 
plans on January 19, 2000. Exchange Act Release No. 42456 (Feb. 24, 
2000), 65 FR 11402 (March 2, 2000). CBOE and Amex submitted 
identical plans. PCX and Phlx submitted plans that were distinct 
from the CBOE/Amex plan and from each other. On July 28, 2000, the 
Commission approved the plan proposed by Amex and CBOE, which ISE 
joined after the Commission approved its exchange application. 
Exchange Act Release No. 43086 (July 28, 2000), 65 FR 48023 (August 
4, 2000) (``Linkage Approval Order''). In November 2000, PCX and 
Phlx also joined that plan. Exchange Act Release Nos. 43573 (Nov. 
16, 2000), 65 FR 70851 (Nov. 28, 2000) (admitting Phlx) and 43574 
(Nov. 16, 2000) 65 FR 70850 (Nov. 28, 2000) (admitting PCX).
    \76\ See Exchange Act Section 11A(a)(1)(C)(iv). 15 U.S.C. 78k-
1(a)(1)(C)(iv).
    \77\ Section 8(c) of the Plan for the Purpose of Creating and 
Operating an Intermarket Option Linkage (``Linkage Plan'') states: 
``The Participants agree that, absent reasonable justification and 
during normal market conditions, members in their markets should not 
effect Trade-Throughs.''
---------------------------------------------------------------------------

    The linkage provides market participants with an automated means 
for accessing the best prices in the options markets, no matter which 
exchange is offering those prices at a given time. Moreover, by 
discouraging market participants from trading at prices inferior to the 
NBBO, the linkage will likely enhance price competition across 
markets.\78\ Therefore, the linkage may help to ameliorate some of the 
competitive and best execution concerns that payment for order flow and 
internalization raise.\79\
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    \78\ The Linkage Plan does not prohibit one market from trading 
through a superior quote on another market. Rather, it requires 
market participants to avoid initiating a trade-through, unless an 
exception applies (e.g., the bid or offer traded through was being 
disseminated from an exchange whose quotes were not firm with 
respect to that option class). In addition, under the Linkage Plan, 
if the party whose quote was traded through complains, the market 
participant that initiated the trade-through must (unless it cancels 
the offending trade) either (1) send an order through the linkage to 
satisfy the quote that was traded through or (2) correct the price 
of the trade that constituted the trade-through to a price at which 
a trade-through would not have occurred. The price correction must 
then be reported through OPRA. See Section 8 of the Linkage Plan. If 
a market participant receives an order when it is not quoting at the 
NBBO, it may execute the order at the NBBO without violating the 
Linkage Plan. Linkage Approval Order, 65 FR at 48026. 
Notwithstanding the lack of a trade-through prohibition in the 
Linkage Plan, a broker-dealer that exhibits a pattern or practice of 
initiating trade-throughs may be in violation of the securities laws 
and rules, including best execution principles and SRO rules 
regarding just and equitable principles of trade.
    \79\ See Linkage Approval Order, 65 FR at 48029.
---------------------------------------------------------------------------

D. Applying the Quote Rule to Options

    In December 2000, the Commission amended Exchange Act Rule 11Ac1-
1,\80\ (``Quote Rule'') to apply it to options, in another move 
designed to improve market transparency and price competition in the 
options markets.\81\ The Quote Rule requires national securities 
exchanges and associations to establish procedures for collecting from 
their members bids, offers, and quotation sizes for reported securities 
and for making that information available to vendors. The rule also

[[Page 6134]]

requires that broker-dealers' quotations be firm, subject to certain 
exceptions.
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    \80\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
    \81\ Exchange Act Release No. 43591 (Nov. 17, 2000), 65 FR 75439 
(Dec. 1, 2000). In addition to amending the Quote Rule to apply to 
options, the Commission adopted a trade-through disclosure rule. 
Under that rule, Exchange Act Rule 11Ac1-7, which the Commission 
repealed in December 2002, broker-dealers, with certain exceptions, 
were required to disclose to their customers the fact that the 
customers' orders to buy or sell listed options were executed at 
prices inferior to the best quotes that were published at the time 
the customers' orders were executed. The rule did not apply to 
customer orders that were executed on options markets that 
participated in an intermarket linkage plan approved by the 
Commission that had provisions reasonably designed to limit 
intermarket trade-throughs. See id., 65 FR at 75443-47. See also 
Exchange Act Release No. 47013 (Dec. 17, 2002), 67 FR 79454 (Dec. 
27, 2002) (repealing Rule 11Ac1-7).
---------------------------------------------------------------------------

    The Quote Rule has applied in the equities markets since 1978.\82\ 
The rule was not applied to options at that time, however, because they 
had only begun to trade a few years earlier.\83\ Although each of the 
options exchanges had adopted rules requiring their market makers or 
specialists to have firm quotes for public customers, the rules did not 
extend to other market participants and were subject to exceptions 
unavailable in the Commission's Quote Rule.\84\ In the release 
proposing to apply the Quote Rule to options, the Commission stated:
---------------------------------------------------------------------------

    \82\ See Exchange Act Release No. 14415 (Jan. 26, 1978), 43 FR 
4342 (adopting Rule 11Ac1-1 for equity securities). See also 
Exchange Act Release No. 14711 (April 27, 1978), 43 FR 18556 
(deferring effective date of rule to August 1978).
    \83\ Exchange Act Release No. 14415, supra note at n.49.
    \84\ Id. at 75442.

    The reliability and availability of quotation information are 
basic components of a national market system and are needed so that 
broker-dealers are able to make best execution decisions for their 
customers' orders, and customers are able to make order entry 
decisions. Quotation information has significant value to the 
marketplace as a whole because a quotation reflects the considered 
judgment of a market professional as to the various factors 
affecting the market, including current levels of buying and selling 
interest. Both retail and institutional investors rely on quotation 
information to understand the market forces at work at any given 
time and to assist in the formulation of investment strategies.
* * * * *
    The Commission is proposing a firm quote rule for options [in 
conjunction with a trade-through disclosure rule] to ensure that the 
published quotes of options exchanges are accessible to orders from 
both customers and broker-dealers. Currently, the options exchanges' 
quotes need not be firm for broker-dealer orders. Therefore, market 
markers on an exchange may not be able to trade with quotes on 
competing exchanges even when these market makers are representing 
customer orders. Yet market makers are expected to match the prices 
on competing exchanges or to trade with those quotes, before trading 
at an inferior price. * * * A firm quote requirement for options is 
needed to ensure that these quotes will, in fact, be honored when 
orders are routed from other markets.\85\
---------------------------------------------------------------------------

    \85\ Exchange Act Release No. 43085 (July 28, 2000), 65 FR 
47918, 47925 (August 4, 2000).
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E. Enforcement Settlement

    The September 2000 regulatory settlement between Amex, CBOE, Phlx, 
PCX, and the Commission as well as a separate settlement between these 
exchanges and the Department of Justice were also designed to enhance 
transparency and competitiveness in the options markets.\86\ Among 
other things, in the settlement with the Commission, the options 
exchanges agreed to remove or amend certain rules and procedures that 
may have hindered or prevented the multiple listing of options. For 
example, the exchanges were required to remove provisions from the 
Joint-Exchange Options Plan (``JEOP), which sets forth procedures that 
the options exchanges followed to list new options to reduce the amount 
of advance notice that an exchange was required to provide before it 
could begin trading an option that was already trading on another 
exchange.\87\ In July 2001, the Commission approved a proposal filed by 
all of the options exchanges as well as the Options Clearing 
Corporation to replace the JEOP with the Options Listing Procedures 
Plan.\88\
---------------------------------------------------------------------------

    \86\ See Exchange Act Release No. 43268 (Sept. 11, 2000) (``SEC 
Settlement Order'') and United States v. American Stock Exchange 
LLC, et al, Proposed Order, Stipulation and Competitive Impact 
Statement, 65 FR 57829 (Sept. 26, 2000). In the SEC Settlement 
Order, the Commission found, among other things, that the options 
exchanges listed in the settlement failed to comply with Exchange 
Act Rule 19c--5 as incorporated into their respective rules by 
refraining from multiply listing certain options listed on a single 
exchange that were available for multiple listing. SEC Settlement 
Order at text accompanying n. 3.
    \87\ See SEC Settlement Order, supra note, 65 FR at 57840.
    \88\ Exchange Act Release No. 44521 (July 6, 2001), 66 FR 36809 
(July 13, 2001).
---------------------------------------------------------------------------

    Moreover, the exchanges agreed to adopt procedures that prevent the 
exchanges from threatening, harassing, or retaliating against their 
members that seek to trade options already traded on another 
exchange.\89\ In addition, the exchanges agreed to make changes to the 
way in which OPRA acquires and allocates market data transmission 
capacity so that OPRA is not used as a means to limit the multiple 
listing of options.\90\
---------------------------------------------------------------------------

    \89\ Exchange Act Release Nos. 43252 (Sept. 6, 2000), 65 FR 
55653 (Sept. 14, 2000) (SR-Amex-00-50); 43253 (Sept. 6, 2000), 65 FR 
55655 (Sept. 14, 2000) (SR-Amex-00-52); 43251 (Sept. 6, 2000), 65 FR 
55658 (Sept. 14, 2000) (SR-CBOE-00-45); 44131 (March 29, 2001), 66 
FR 18136 (April 5, 2001) (SR-PCX-01-11); and 44057 (March 9, 2001), 
66 FR 15312 (SR-Phlx-01-03).
    \90\ On April 15, 2003, the options exchanges filed with the 
Commission a proposal to amend the OPRA plan to satisfy this 
obligation. See OPRA-2003-01.
---------------------------------------------------------------------------

    Finally, the settlement directs the exchanges to amend their then-
existing rules governing their automated quotation and execution 
systems to increase incentives to quote competitively.\91\ Some of the 
enhancements that have been implemented in connection with the 
Settlement Order are discussed in Section III B4 above.
---------------------------------------------------------------------------

    \91\ SEC Settlement Order, supra note 86, 65 FR at 57841.
---------------------------------------------------------------------------

VI. Additional Steps That Could Be Taken To Address Concerns About 
Payment for Order Flow, Specialist Guarantees, and Internalization

    There are several possible regulatory alternatives that the 
Commission could pursue to address concerns with payment for order 
flow, specialist guarantees, and internalization. These alternatives 
range from taking no regulatory action at this point to banning these 
arrangements. The Commission seeks comments on the alternatives it 
could pursue to address concerns with these arrangements.

A. Should the Commission Take Action at This Point?

    As discussed above, the options markets have undergone fundamental 
changes in the past few years. Options exchanges and market 
participants in those markets continue to adapt to the regulatory 
changes, including the implementation of an intermarket linkage plan, 
application of the Quote Rule, imposition of an order routing 
disclosure rule, and the requirement to price options in decimals. 
Competition among the options markets has led to the development of 
systems that permit greater intramarket competition, which has narrowed 
spreads. Some commentators have suggested that competitive forces in 
the options markets have shown themselves sufficient to increase the 
quality of execution and no further regulatory action is needed at this 
time.\92\
---------------------------------------------------------------------------

    \92\ See Battalio et al, supra note. The authors suggest that 
the increased competition from multiple listing and the threat of 
regulatory action in the form of an intermarket linkage were 
sufficient to improve execution quality in the options markets to a 
level comparable to that of the equities markets and therefore 
additional regulation may not be required.
---------------------------------------------------------------------------

    Question 17. Do recent regulatory changes together with competitive 
forces in the options markets make additional regulatory action at this 
time unnecessary?
    Question 18. What would be the likely consequences to the options 
markets in terms of competition and execution quality should the 
Commission decide to take no regulatory action at this time? 
Specifically, do commenters believe that the current trend toward 
narrower spreads in the options markets could itself eliminate payment 
for order flow, specialist guarantees, and internalization?

[[Page 6135]]

B. Should the Commission Require Brokers to Rebate All or a Portion of 
Payments They Receive?

    One of the principal concerns about payment for order flow is that 
it creates a conflict with a broker's best execution obligation. 
Requiring brokers to rebate to their customers any payments they 
receive in exchange for routing those customers' orders to a particular 
exchange may mitigate much of the conflict.
    Question 19. Should brokers that receive payment for order flow be 
required to rebate all or a certain portion of those payments to their 
customers or demonstrate that the economic benefit of payment for order 
flow has been passed on to customers? If so, how should the amount of 
any such rebate be determined, and how would a firm demonstrate that it 
passed the payment for order flow benefit to customers?
    Question 20. How would any non-cash inducements to route order flow 
be valued for purposes of any such rebate?

C. Should the Commission Ban Payment for Order Flow, Specialist 
Guarantees, and Internalization?

    The Commission could decide that payment for order flow, specialist 
guarantees, and internalization in the options markets impair the 
integrity of those markets and pose harm to investors and ban such 
arrangements or significantly limit them.
    Question 21. What would be the effect of banning all payment for 
order flow arrangements in the options markets? If the Commission 
determined that a ban on payment for order flow were warranted, would a 
ban only on cash payments be sufficient or would non-cash inducements 
also have to be banned? If commenters believe that the Commission 
should impose such a ban, could such a ban be easily evaded in light of 
the numerous forms that payment for order flow arrangements can take?
    Question 22. If the Commission were to ban all payment for order 
flow, but continue to permit firms to internalize their customers' 
orders, would it provide an unfair advantage to integrated firms that 
have customer order flow they can internalize? If a ban on payment for 
order flow unfairly advantaged integrated firms with broker and dealer 
operations, should the Commission revisit the issue of whether firms 
should be permitted to operate both as a broker and as a dealer for 
customer options orders? \93\
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    \93\ See SEC, Report on the Feasibility and Advisability of the 
Complete Segregation of the Functions of Dealer and Broker (June 20, 
1936) (``Segregation Study'').
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    Question 23. Should the Commission ban some or all specialist 
guarantees and internalization (i.e., dealer participation 
arrangements) in the options markets? Should any such ban only be done 
in conjunction with a ban on payment for order flow?
    Question 24. What would be the impact, if any, on competition in 
the options markets if the Commission were to ban either payment for 
order flow or dealer participation arrangements without banning the 
other type of arrangement?
    Question 25. What would be the impact of a complete ban on all such 
practices? For example, if the Commission banned payment for order flow 
and dealer participation arrangements, who would benefit? Would 
specialists and market makers quote better prices? Would they retain 
the economic benefit they now share with order entry firms? What effect 
would a ban have on non-dominant markets or firms seeking to attract 
order flow from the dominant market participants?
    Question 26. In response to a recent request for the views of the 
options markets on payment for order flow arrangements, one of the 
markets stated that the Commission's review of payment for order flow 
and internalization should not be limited to the options markets but 
rather should include the equities markets as well.\94\ Are there 
differences between the equities and options markets that warrant 
different treatment? If so, what are those differences? If different 
treatment is not warranted, should the Commission consider a market-
wide ban on payment for order flow and dealer participation 
arrangements?
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    \94\ Letter to Harvey L. Pitt, Chairman, SEC from Salvatore F. 
Sodano, Chairman & CEO, Amex (Feb. 10, 2003).
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D. Should the Commission Ban Only Exchange-Sponsored Payment for Order 
Flow?

    On February 3, 2003, Phlx filed with the Commission a petition for 
rulemaking that asks the Commission to ban exchange-sponsored payment 
for order flow programs, citing many of the concerns about payment for 
order flow discussed above.\95\ Similarly, on June 11, 2003, 
Susquehanna International Group, LLP (``Susquehanna'') requested that 
the Commission exempt it from SRO rules that require it to contribute 
to exchange-sponsored payment for order flow programs.\96\ In the 
alternative, Susquehanna requested that the Commission treat the 
exemptive application as a petition for rulemaking under Rule 192 of 
the SEC's Rules of Practice \97\ to repeal transaction and marketing 
fees adopted by various options exchanges.
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    \95\ Letter to Jonathan G. Katz, Secretary, SEC, from Meyer S. 
Frucher, Chairman & CEO, Phlx, (Feb. 3, 2003), Petition for 
Rulemaking File No. 4-474, (``Phlx Petition'').
    \96\ See Letter to Jonathan G. Katz, Secretary, SEC, from Joel 
Greenberg, Chief Legal Officer, Susquehanna International Group, 
LLP, re Application for Exemptive Relief from Exchange Sponsored 
Payment for Order Flow Programs (June 11, 2003), Petition for 
Rulemaking File No. 4-474, (``Susquehanna Petition''). Susquehanna 
states that it is a market maker on every U.S. options exchange 
other than ISE, that it makes a market in 2000 options classes and 
acts as a specialist or designated primary market maker in some 
options classes.
    \97\ 17 CFR 201.192.
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1. Phlx Petition
    In its petition, Phlx asks the Commission to adopt a rule banning 
exchange-sponsored options payment for order flow programs.\98\ 
According to Phlx, exchange-sponsored payment for order flow 
arrangements raise a number of concerns. First, Phlx believes that such 
arrangements can interfere with market forces by ``creating a known and 
stable price point (the exchange-mandated fee) that affects payment for 
order flow negotiations.''
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    \98\ See Phlx Petition, supra note. Phlx submitted its petition 
pursuant to Rule 192 of the Commission's Rules of Practice. 17 CFR 
201.192. Phlx would exclude from its proposed prohibition payment 
for order flow arrangements made directly between individual 
exchange members or between an individual member and a non-member 
broker-dealer. It would also exclude programs or arrangements 
whereby an exchange provides its members with volume discounts or 
rebates or programs in which the exchange shares market data 
revenues with its members.
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    Second, Phlx argues that exchange-sponsored payment for order flow 
arrangements can have detrimental effects on market makers by requiring 
them effectively to subsidize the specialists' order flow payments. 
Phlx contends that this subsidization raises costs for market makers, 
which, to cover those costs, may have to widen their spreads or reduce 
the level of liquidity they provide. Phlx believes that this 
subsidization is inconsistent with Section 11A of the Exchange Act, 
which requires fair competition among brokers and dealers.\99\
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    \99\ 15 U.S.C. 78k-1.
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    Finally, Phlx asserts that exchange-sponsored payment for order 
flow arrangements provide a potential disincentive for an SRO to police 
its members in complying with their regulatory obligations.
    For these reasons, Phlx requests that the Commission adopt a rule 
that would prohibit: (1) An options exchange from

[[Page 6136]]

organizing, sponsoring, or administering a payment for order flow 
program in connection with the routing of options orders; (2) an 
options exchange from imposing fees or assessments to fund payment for 
order flow payments in connection with the routing of options orders; 
and (3) an options exchange member from participating in any options 
payment for order flow program that is organized, sponsored, or 
administered by an options exchange or by any group or association of 
unaffiliated members.
2. Susquehanna Request
    In its letter, Susquehanna asks the Commission, by rulemaking or 
order, to exempt it from SRO rules that require Susquehanna and other 
similarly situated firms to contribute to exchange-sponsored payment 
for order flow programs. Susquehanna argues that such programs are 
detrimental to the markets and market participants in a number of 
respects. For example, Susquehanna believes that forcing market makers 
to participate in the programs will ultimately cause them to widen 
their spreads to pay for the programs, which will raise investors' 
transaction costs. Susquehanna also believes that such programs place 
exchange market makers at a competitive disadvantage versus market 
participants that are not members of the exchange, which are not 
required to pay the exchange-imposed fees. Susquehanna contends that 
exchange-sponsored payment for order flow programs, the fees of which 
are assessed on a per contract basis, unfairly discriminate against 
firms such as Susquehanna, which transact a large number of contracts. 
Moreover, Susquehanna argues that exchange-sponsored payment for order 
flow arrangements drain market maker resources away from other services 
that they could offer to their customers, such as improvements in 
products, technology, customer service, and communications.
    In addition, Susquehanna contends that such programs create a 
conflict of interest for SROs that administer the programs at the same 
time they are tasked with ensuring that their members meet their best 
execution obligations. The firm also contends that such programs damage 
investor confidence by leading investors to believe that their orders 
are routed to the venues that pay for order flow rather than to those 
venues that offer the best price or other execution terms. Finally, 
Susquehanna contends that such programs can be administered in an 
arbitrary and potentially discriminatory manner. For all of these 
reasons, Susquehanna requests that the Commission exempt it (and 
similarly situated firms) from all such exchange-sponsored payment for 
order flow programs.
    The Commission seeks comment generally on the Phlx Petition and on 
the Susquehanna Petition and specifically is requesting comments on the 
following issues raised in those petitions.
    Question 27. What would be the effect on the options markets and 
market participants if the Commission were to restrict only those 
payment for order flow arrangements that are sponsored or sanctioned in 
some way by a registered options exchange, as Phlx has proposed in its 
petition? In particular, would such a restriction favor a specialist 
that can be assured of trading with the largest proportion of order 
flow routed to its exchange? In other words, would such a ban unfairly 
disadvantage an exchange on which market makers compete more 
aggressively with the specialist?
    Question 28. Would banning exchange-sponsored programs, while 
continuing to permit other types of payment for order flow and dealer 
participation arrangements, address the concerns discussed above 
regarding wider spreads, best execution, and SRO conflicts of interest?

E. Should the Commission Establish Uniform Rules and Enforcement 
Standards Regarding Internalization and Specialist Guarantees?

    With respect to facilitation guarantees, the Commission has stated 
that it is a violation of a broker-dealer's best execution obligation 
to withdraw a facilitated order that may be price improved on one 
market to avoid executing the order at the superior price.\100\ CBOE 
contends, however, that in the absence of uniform rules and policies 
across all options exchanges that would curb such trading behavior, 
none of the options exchanges is able, on its own, to prevent it. CBOE 
contends that industry efforts over the past several months to address 
potentially abusive facilitation practices have been unsuccessful due 
to the exchanges' varying views regarding these issues. Therefore, CBOE 
has asked the Commission to impose uniform rules and enforcement 
standards that would apply in this area. In particular, CBOE recommends 
that the Commission take action to ensure that ``options exchanges' 
rules allow an executing broker to participate with some portion of its 
customer's order only if [the] order has been exposed first to the 
market in a manner that provides a meaningful opportunity for price 
improvement.'' \101\
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    \100\ See supra note 60 and accompanying text.
    \101\ Letter to Harvey L. Pitt, Chairman, SEC, from William J. 
Brodsky, Chairman & CEO, CBOE (Feb. 10, 2003).
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    Question 29. Should the Commission take action, as CBOE recommends, 
to prohibit a broker from internalizing all or part of its customers' 
orders if those orders have not first been exposed to the market in a 
manner that provides what CBOE terms ``a meaningful opportunity'' for 
price improvement? What would constitute ``a meaningful opportunity'' 
for price improvement? \102\
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    \102\ For point of reference, see Exchange Act Release No. 46514 
(Sept. 18, 2002), 67 FR 60267 (Sept. 18, 2002) (order approving File 
No. SR-ISE-2001-19 regarding facilitation of customer orders, 
wherein the Commission stated its belief that: ``in the ISE's fully 
automated market, a 10-second response period will afford electronic 
crowds sufficient time to compete for customer orders submitted by 
an E[lectronic] A[ccess] M[ember] into the Exchange's Facilitation 
Mechanism, thereby promoting just and equitable principles of trade, 
protecting investors and the public interest, and not imposing any 
burden on competition'' and ``the Commission believes that the 
timeframes necessary for exposure and execution of orders be 
adjudged in light of that marketplace's model. For this reason, the 
Commission does not believe that a fully automated market such as 
the ISE should be tied to timeframes relevant to the procedures of a 
floor-based exchange.'')
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    Question 30. Do the options exchanges' current rules requiring that 
an order first be exposed to an auction before a firm can internalize 
it provide a meaningful opportunity for price improvement?
    Question 31. What improvements could be made to the current 
framework for cross-market surveillance in the options markets to 
improve the ability of SROs to bring a best execution case against a 
broker that presents an order to be facilitated on one market and 
cancels that order, later executing it at an inferior price on another 
market?
    Question 32. Are there other practices, occurring frequently with 
respect to facilitation guarantees that are inconsistent with best 
execution obligations? For example, are there circumstances under which 
an upstairs firm should not be permitted to ``shop'' an order it is 
seeking to facilitate at more than one exchange to determine where it 
can get the most favorable terms for that order?
    Question 33. Are the options exchanges' rules with respect to 
facilitation guarantees (and the application of those rules) consistent 
regarding which conduct should and should not be permitted?

F. Should the Commission Apply Rule 11Ac1-5 to Options?

    In 2000, when the Commission deferred applying Rule 11Ac1-5 to

[[Page 6137]]

options, it noted ``potentially difficult issues would have to be 
addressed before options could be included within Rule 11Ac1-5.'' These 
issues include the creation of an NBBO for the options markets and the 
practical problem of the categorization of orders on a security-by-
security basis, given that there may be hundreds of series of options 
for each underlying equity security. The Commission continues to 
believe that execution quality information benefits investors and other 
market participants in determining which markets offer the type of 
execution that they value.
    As discussed above, OPRA has begun offering vendors an NBBO for the 
options markets, thereby removing one of the key obstacles to extending 
Rule 11Ac1-5 to options. Although the OPRA NBBO is somewhat limited in 
that it does not reflect price changes of less than $0.05 or update 
size changes of fewer than 10 contracts (in the absence of a price 
change), it would appear to provide options exchanges with a 
standardized NBBO that would permit them to make the calculations 
required by Rule 11Ac1-5.\103\
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    \103\ For example, Rule 11Ac1-5 requires market centers to 
disseminate for market orders and marketable limit orders the 
average effective spread for executions of orders covered by the 
rule. The ``average effective spread'' is the share-weighted average 
of effective spreads for order executions calculated, for buy 
orders, as double the amount of difference between the execution 
price and the midpoint of the consolidated best bid and offer at the 
time of order receipt. See Rule 11Ac1-5 (a)(2).
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    Question 34. Would Rule 11Ac1-5 data be useful to firms routing 
customers' options orders to exchanges and to those customers?
    Question 35. If Rule 11Ac1-5 data would be useful for options 
orders, what adjustments, if any, would options market centers need to 
make to calculate and disseminate Rule 11Ac1-5 statistics? For example, 
is the OPRA NBBO a sufficient measure to enable market centers to make 
the Rule 11Ac1-5 calculations that require a consolidated BBO? If not, 
what changes would need to be made to the OPRA NBBO to make it suitable 
for such calculations?
    Question 36. Are there other reasons why Rule 11Ac1-5 should not be 
applied to the options markets? For example, do the anticipated 
benefits of having better execution quality information for the 
respective options market centers justify the costs that the market 
centers would incur in calculating and disseminating the Rule 11Ac1-5 
statistics?

G. Would Penny Quotes in Options Reduce Payment for Order Flow?

    The Commission believes that an argument can be made that payment 
for order flow may be a symptom of a broader problem of an inefficient 
market that can be rectified only by better aligning the quoting 
increments of the options markets with those of the equities markets. 
With few exceptions, the U.S. equities markets quote in minimum 
increments of one cent, while the options markets continue to quote in 
ten-cent increments for options priced $3.00 and over and five-cent 
increments for options priced under $3.00. As discussed above, research 
with respect to equity securities has indicated that the move to penny 
increments has greatly reduced spreads in equities,\104\ which, in 
turn, appears to have played a role, at least in the short-term, in 
reducing payment for order flow. The same result could occur with 
respect to options if the minimum pricing increment decreased to one 
cent.
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    \104\ See supra note 72 and accompanying text.
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    Question 37. If options were quoted in penny increments, would 
payment for order flow in the options markets cease or be diminished?
    Question 38. Would a move to penny quoting in the options markets 
place an undue strain on existing system capacity? If so, which market 
participants would be most negatively impacted (e.g., broker-dealers, 
exchanges, vendors)?
    Question 39. If so, are there ways to alleviate potential strains 
on system capacity to allow the options markets to begin quoting in 
penny increments?
    Question 40. Are there other issues that make a move to penny 
quoting in the options markets infeasible or inadvisable? For example, 
what would be the impact on the rapidity of quote changes (i.e., 
``flickering quotes'')?
    Question 41. If exchanges required brokers to pay directly for the 
capacity that they use, would the brokers quote more efficiently, and 
thereby make a move to penny pricing in the options markets more 
feasible?

H. Should the Commission Apply the Limit Order Display Rule to Options?

    As discussed above, in December 2000, the Commission extended the 
Quote Rule to the options markets. Exchange Act Rule 11Ac1-4 (``Limit 
Order Display Rule''),\105\ a rule that complements the Quote Rule and 
that is in place in the equities markets, does not currently apply to 
options. Adoption of the Limit Order Display Rule, as well as other 
order handling rules, in the equity markets dramatically narrowed 
spreads as customer limit orders began to compete with the quotes of 
market professionals to set the best prices in the market.\106\
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    \105\ 17 CFR 240.11Ac1-4.
    \106\ NASD found that, as a result of the Limit Order Display 
Rule and other market structure changes implemented at the time, 
quoted spreads in the securities NASD studied declined, on average, 
by forty-one percent. Effective spreads declined, on average, by 
twenty-four percent. See NASD Economic Research, Market Quality 
Monitoring: Overview of 1997 Market Changes (March 17, 1998).
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    With certain exceptions, Rule 11Ac1-4 requires, among other things, 
that specialists and over-the-counter market makers immediately publish 
customer limit orders that improve the specialist's or market maker's 
quote in a particular security.\107\ While certain of the options 
exchanges have proposed rules that would require the immediate display 
of customer limit orders,\108\ currently there is no uniform limit 
order display requirement that applies across the options markets. 
Nevertheless, the increase in intramarket competition brought about by 
certain of the market structure changes discussed above could suggest 
that a uniform limit order display rule should apply to the options 
markets.
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    \107\ 17 CFR 240.11Ac1-4(b). In the alternative, the specialist 
or market maker may, among other things, immediately execute the 
limit order or route it to another market center that will display 
it. 17 CFR 240.11Ac1-4(c).
    \108\ See, e.g., Exchange Act Release Nos. 43126 (August 7, 
2000), 65 FR 49621 (August 14, 2000) (seeking public comment on File 
No. SR-Phlx-00-34) and 43550 (Nov. 13, 2000), 65 FR 69979 (Nov. 21, 
2000) (seeking public comment on File No. SR-PCX-00-15). See also 
File No. SR-Amex-00-27.
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    Question 42. Should the Commission apply a limit order display 
obligation to the options markets?
    Question 43. Would the benefits of a uniform display requirement 
justify the costs of imposing such an obligation on options market 
participants?
    Question 44. Do the options markets have unique characteristics 
that would make the application of a uniform limit order display 
obligation there less feasible than in the equities markets? If so, 
what are those characteristics?
    Question 45. If a limit order display obligation would be 
beneficial for the options markets, what modifications, if any, to Rule 
11Ac1-4, would be required before it could be applied to options market 
participants?
    Question 46. If a uniform limit order display requirement is not 
appropriate for the options markets, are there other safeguards that 
could be put in place to ensure that customer limit orders are 
immediately displayed?

[[Page 6138]]

VII. Solicitation of Additional Comments

    In addition to the areas for comment identified above, we are 
interested in any other issues that commenters may wish to address 
relating to the options markets. Please be as specific as possible in 
your discussion and analysis of any additional issues. Where possible, 
please provide empirical data or observations of market trends to 
support or illustrate your comments.

    By the Commission.
    Dated: February 3, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-2646 Filed 2-6-04; 8:45 am]
BILLING CODE 8010-01-P