[Federal Register Volume 76, Number 130 (Thursday, July 7, 2011)]
[Notices]
[Pages 39953-39958]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-16922]



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SECURITIES AND EXCHANGE COMMISSION



[Release No. 34-64781; File No. SR-BATS-2011-009]




Self-Regulatory Organizations; BATS Exchange, Inc.; Notice of 

Filing of Amendment No. 2 and Order Granting Accelerated Approval to 

Proposed Rule Change, as Modified by Amendment Nos. 1 and 2 Thereto, to 

Create, on a Six-Month Pilot Basis, a Directed Order Program



June 30, 2011.



I. Introduction



    On March 16, 2011, BATS Exchange, Inc. (the ``Exchange'' or 

``BATS'') filed with the Securities and Exchange Commission 

(``Commission''), pursuant to Section 19(b)(1) of the Securities 

Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a 

proposal to establish, on a six-month pilot basis, a directed order 

(``Directed Order'') program on its options facility (``BATS



[[Page 39954]]



Options''). On March 24, 2011, BATS filed Amendment No. 1 to the 

proposed rule filing. The proposed rule change, as modified by 

Amendment No. 1, was published for comment in the Federal Register on 

April 1, 2011.\3\ The Commission received 13 comment letters from 8 

commenters on the proposal,\4\ and a letter from BATS responding to the 

comment letters.\5\ On June 2, 2011, BATS filed Amendment No. 2 to the 

proposed rule change.\6\ The Commission is publishing this notice to 

solicit comments on Amendment No. 2 from interested persons, and is 

approving the proposal, as modified by Amendment Nos. 1 and 2, on an 

accelerated basis, for a six-month pilot period ending January 30, 

2012.

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    \1\ 15 U.S.C. 78s(b)(1).

    \2\ 17 CFR 240.19b-4.

    \3\ See Securities Exchange Act Release No. 64132 (March 28, 

2011), 76 FR 18280 (``Notice'').

    \4\ See Letters to Elizabeth M. Murphy, Secretary, Commission, 

from Jennifer M. Lamie, Assistant General Counsel, Legal Division, 

Chicago Board Options Exchange (``CBOE''), dated June 29, 2011 

(``CBOE II Letter''); Tom Wittman, The NASDAQ OMX PHLX, Inc. and The 

NASDAQ Options Market (together ``Nasdaq''), dated June 24, 2011 

(``Nasdaq II Letter''); Janet L. McGinness, SVP & Corporate 

Secretary, Legal & Government Affairs, NYSE Euronext, dated June 17, 

2011 (``NYSE Euronext II Letter''); Michael J. Simon, Secretary, 

International Securities Exchange, LLC (``ISE''), dated June 17, 

2011 (``ISE II Letter''); Anthony D. McCormick, Chief Executive 

Officer, BOX Options Exchange Group, LLC (``BOX'')), dated June 13, 

2011 (``BOX II Letter''); Angelo Evangelou, Assistant General 

Counsel, Legal Division, CBOE, dated April 27, 2011 (``CBOE I 

Letter''); John C. Nagel, Managing Director and General Counsel, 

Asset Management and Markets, Citadel LLC, dated April 25, 2011 

(``Citadel Letter''); Andrew Stevens, Legal Counsel, IMC Chicago, 

LLC d/b/a IMC Financial Markets, dated April 21, 2011 (``IMC 

Letter''); Janet L. McGinness, SVP & Corporate Secretary, Legal & 

Government Affairs, NYSE Euronext, dated April 21, 2011 (``NYSE 

Euronext I Letter''); Kurt Eckert, Principal, Wolverine Trading, 

LLC, dated April 21, 2011 (``Wolverine Letter''); Tom Wittman, 

Nasdaq, dated April 21, 2011 (``Nasdaq I Letter''); Michael J. 

Simon, Secretary, ISE, dated April 21, 2011 (``ISE I Letter''); and 

Anthony D. McCormick, Chief Executive Officer, BOX, dated March 29, 

2011 (``BOX I Letter'').

    \5\ See Letter to Elizabeth M. Murphy, Secretary, Commission, 

from Jeromee Johnson, BATS, dated June 2, 2011 (``BATS Letter'').

    \6\ In response to comments received on the proposed rule 

change, as modified by Amendment No. 1 thereto, the Exchange filed 

Amendment No. 2 to revise the proposed rule change to permit BATS 

Options Members to send Directed Orders to more than one BATS 

Options market maker.

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II. Description of the Proposed Rule Change, as Modified by Amendment 

Nos. 1 and 2



    The Exchange proposes to allow members of BATS Options (``Options 

Members'') to direct orders to BATS Options market makers under certain 

conditions. Specifically, the proposal would establish two new order 

types--a ``Directed Order'' and a ``Market Maker Price Improving 

Order'' (MMPIO). A Directed Order would be an order directed by an 

Options Member to one or more BATS Options market makers for possible 

execution against the MMPIO of the BATS Options market maker(s).\7\ To 

direct an order to a particular BATS Options market maker, the Options 

Member must be on a list of eligible Options Members provided to the 

Exchange by the BATS Options market maker.\8\

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    \7\ As originally proposed, Options Members could only send 

Directed orders to one BATS Options market maker. In Amendment No. 

2, BATS revised the proposal to permit Options Members to send 

Directed Orders to more than one BATS Options market maker.

    \8\ BATS Rule 21.1(d)(14).

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    To be eligible to receive a Directed Order, a BATS Options market 

maker must enter a MMPIO. The MMPIO would contain both a displayed 

price, as well as a better non-displayed price at which the market 

maker is willing to trade with a Directed Order. The MMPIO would be 

ranked on the BATS Options book at its displayed price. The non-

displayed price would not be entered on the BATS Options book, but 

instead would be converted to a buy or sell order at the non-displayed 

price in response to a Directed Order directed to the market maker, up 

to the full displayed size of the MMPIO. Thus, an incoming marketable 

non-Directed Order would execute against the market maker's displayed 

quote, not its non-displayed better price. To be able to participate in 

an execution against a Directed Order: (i) The market maker must be 

quoting on BATS with a MMPIO that contains a displayed price at the 

NBBO at the time the Directed Order arrives on BATS; (ii) the non-

displayed price of the MMPIO must be at a price better than the NBB 

(for sell Directed Orders) or the NBO (for buy Directed Orders) and 

marketable against the Directed Order; \9\ and (iii) as noted above, 

the Directed Order must have come from an Options Member on the market 

maker's list of eligible Options Members.

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    \9\ The non-displayed price also must be at least one cent 

better than the NBB or NBO, as applicable.

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    If the above conditions in (i), (ii), and (iii) are met, and if 

there are no other non-displayed orders at prices equal to or better 

than the non-displayed price of the MMPIO, the Directed Order will 

trade with the MMPIO up to the full size of the MMPIO. If there are 

non-displayed orders on the BATS Options book at prices equal to or 

better than the non-displayed price of the MMPIO, those other non-

displayed orders will in all cases have priority over the non-displayed 

price of the MMPIO. In such circumstances, the MMPIO may still execute 

at its non-displayed price against the Directed Order to the extent of 

any remaining contracts of the Directed Order. If a Directed Order is 

directed to more than one BATS Options market maker, such Directed 

Order will execute in price/time priority based on the non-displayed 

price of such orders, to the extent the Directed Order can execute 

against any MMPIO.\10\

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    \10\ See Amendment No. 2.

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    BATS notes that, if an Options Member notifies a BATS Options 

market maker of its intention to submit a Directed Order so that the 

BATS Options market maker could change its quotation to match the NBB 

or NBO immediately prior to submission of the Directed Order, the 

parties would be engaging in conduct inconsistent with just and 

equitable principles of trade in violation of BATS Rules 3.1 and 

18.4(f). In addition, BATS notes that a BATS Options market maker who 

becomes aware of a customer order from an affiliated broker-dealer or 

desk within the same broker-dealer and acts on such information to 

change its quotations to match the NBB or NBO immediately prior to 

submission of a Directed Order would be in violation of the BATS Rule 

22.10, ``Limitations on Dealings.'' BATS represents that it will 

proactively conduct surveillance for such conduct and enforce against 

such violations.\11\

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    \11\ One commenter on the proposal believes that the proposed 

rule change does not address whether it would be permissible for a 

BATS Options market maker to share the details of its MMPIO, whether 

existing or prospective, with an order flow provider (affiliated or 

otherwise) so that the order flow provider could make routing 

decisions based on this information. See NYSE Euronext I Letter at 

5-6. If a BATS Options market maker informs an order entry firm of 

its intention to modify its quotation or details about its MMPIO so 

that the BATS Options Member could send a Directed Order to the BATS 

Options market maker, BATS would view this as pre-arranged trading 

and would consider this to be a violation of BATS Rules 3.1 (just 

and equitable principles of trade) and 18.4(f) (misuse of material 

non-public information). See E-mail to David Hsu, Assistant 

Director, Division of Trading and Markets, Commission, from Anders 

Franzon, BATS, dated June 27, 2011. If the order entry firm was an 

affiliate or a desk within the same firm as the BATS Options market 

maker, and the BATS Options market maker shared information 

regarding its planned quoting activities or details about the market 

maker's MMPIO, then BATS would consider this to be a violation of 

BATS Rule 22.10 (Limitation on Dealings). Id.

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    BATS proposes to establish its Directed Order program on a six-

month pilot basis. BATS represents that, during the pilot period, it 

will study the impact of the rules and will provide the Commission with 

monthly reports detailing its ongoing review of the pilot. Such reports 

would include statistics with respect to:

     The number of Directed Orders submitted to BATS Options;



[[Page 39955]]



     The number of MMPIOs submitted to BATS Options;

     Information regarding the types of market participants 

that sent Directed Orders;

     The number of Market Makers that participated in the 

directed order program;

     The percentage of time that Market Makers participating in 

the directed order program were at the NBBO when a Directed Order 

arrived at BATS Options;

     The number of orders, excluding MMPIOs, against which an 

incoming Directed Order executed;

     The proportion of each Directed Order that was executed 

against a MMPIO;

     The percentage of Directed Orders that received price 

improvement over the NBBO;

     The average amount of price improvement for Directed 

Orders; and

     Data related to the quality of the best bid and offer on 

BATS Options.



III. Summary of Comments



    The Commission received 13 comment letters from 8 commenters 

opposing the proposal.\12\ These commenters generally argue that, 

because Directed Orders will not be exposed to meaningful competition, 

the proposal will disincent market makers from quoting aggressively and 

negatively impact the price at which the Directed Orders are 

executed.\13\

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    \12\ See supra note 4. In addition, the Commission notes that in 

response to an earlier Directed Order proposal filed and later 

withdrawn by the Exchange (SR-BATS-2010-034) that was substantially 

similar to the instant proposal (the ``Prior Proposal''), one 

commenter had stated that the proposal would be beneficial to retail 

investors by providing firms with competitive opportunities to seek 

price improvement on client option orders. See Letter to Elizabeth 

M. Murphy, Secretary, Commission, from Christopher Nagy, Managing 

Director, Order Strategy, TD Ameritrade, dated December 23, 2010 

(``Ameritrade Letter'').

    \13\ See BOX I Letter at 1; BOX II Letter at 1-2; CBOE I Letter 

at 2; Citadel Letter at 2; IMC Letter at 2; ISE I Letter at 3; ISE 

II Letter at 3; Nasdaq I Letter at 3; NYSE Euronext I Letter at 3; 

NYSE Euronext II Letter at 4; and Wolverine Letter at 1.

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    Several commenters argue that the lack of a requirement that the 

Directed Order be exposed to all market participants or be subject to a 

separate auction mechanism will prevent other market participants from 

any opportunity to provide further price improvement to the Directed 

Order, and thus harm the Directed Order.\14\ Several commenters argue 

that other market participants will not be able to effectively compete 

with a BATS Options market maker with a MMPIO because, although other 

market participants also can enter orders that have a non-displayed 

price on the BATS book at a price equal to or better than the non-

displayed price of the MMPIO,\15\ that non-displayed price would be at 

risk to all incoming marketable orders, not just Directed Orders from a 

select list of eligible customers.\16\ Commenters further argue that 

other market participants are at a further competitive disadvantage 

vis-[agrave]-vis BATS options market makers with MMPIOs in one cent MPV 

options because BATS Options market makers would be able to enter 

MMPIOs with non-displayed prices in penny increments, but other market 

participants could not enter orders with non-displayed prices in penny 

increments.\17\ Several commenters argue that BATS Options market 

makers will be able to enter MMPIOs with better non-displayed prices 

than other competing market participants, thus effectively resulting in 

100 percent internalization of Directed Orders (assuming the 

participating market maker is always willing to provide prices better 

than the NBBO) without the opportunity for exposure.\18\ In addition, a 

few commenters argue that price discovery will be negatively impacted 

by the perpetuation of a two-tiered market for customers--one market 

reflecting publicly available prices and sizes, and another market 

reflecting a non-public pool of liquidity available for only certain 

approved customers.\19\

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    \14\ See BOX I Letter at 1-2; CBOE I Letter at 2-3; CBOE II 

Letter at 3-5; IMC Letter at 2; ISE I Letter at 4; Nasdaq I Letter 

at 3; NYSE Euronext I Letter at 4, and NYSE Euronext II Letter at 3-

4. See also BOX II Letter at 2 (arguing that, if BATS Options market 

makers receive Directed Orders from only their list of eligible 

Options Members, the ``cost of that enjoyment should be the 

requirement that directed orders be exposed on the market or subject 

to a specific auction mechanism so that customers enjoy the greatest 

amount of opportunity for price improvement'') and IMC Letter at 2 

(stating that the structure of the BATS Directed Order program 

``unduly limits competition as such does not contribute to price 

discovery.''). In addition, BOX states that, because the proposal 

permits only BATS Options market maker(s) designated by the Options 

Member to compete for the Directed Order, and such designation is at 

the discretion of the Options Member, a ``substantial conflict of 

interest may arise,'' incenting BATS Options market makers to 

significantly increase payment for order flow payments so that they 

can be the sole destination for the Option Member's customer orders. 

See BOX II Letter at 1-2. This commenter also argues that, although 

the rule would allow an Options Member to submit Directed Orders to 

multiple BATS Options Market Makers, competition for the order is 

still limited because the order would be exposed to some--but not 

all--market participants. See BOX II Letter at 1-2.

    \15\ In options with a five or ten cent minimum price variation 

(``MPV''), other market participants would be able to enter a non-

displayed price using a Price Improving Order to compete with MMPIOs 

for Directed Orders. A Price Improving Order would receive priority 

over MMPIOs at the same non-displayed price. However, the non-

displayed price of a Price Improving Order would be available to all 

incoming marketable orders, in contrast to the non-displayed price 

of an MMPIO, which would only be available to incoming Directed 

Orders.

    \16\ See, e.g., CBOE I Letter at 2; CBOE II Letter at 4; Citadel 

Letter at 2; IMC Letter at 2; ISE I Letter at 3; ISE Letter II at 1-

2; Nasdaq I Letter at 2, Nasdaq II Letter at 1, and NYSE Euronext II 

Letter at 4.

    \17\ See CBOE I Letter at 2; CBOE II Letter at 2; Citadel Letter 

at 2; IMC Letter at 2; and Nasdaq I Letter at 2. These commenters 

believe that, because the orders of these market participants would 

be displayed in options with a one cent MPV, they would be at 

greater risk of being executed against informed order flow. On the 

other hand, because MMPIOs may be entered in increments as small as 

one cent and are not displayed, BATS Options market makers with 

MMPIOs are not subject to the same risk. Id. See also NYSE Euronext 

II Letter at 4.

    \18\ See Citadel Letter at 2-3; Nasdaq I Letter at 2-3; and 

Nasdaq II Letter at 2.

    \19\ See Citadel Letter at 2; ISE I Letter at 2; and Wolverine 

Letter at 2. See also CBOE I Letter at 3 and CBOE II Letter at 2, 

wherein CBOE argues that the MMPIO is inconsistent with Rule 602 of 

Regulation NMS, 17 CFR 242.602 (the ``Quote Rule''), because the 

BATS proposal would only require the MMPIO to be firm for pre-

selected Directed Order participants (as opposed to all incoming 

interest received by BATS).

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    In response to commenters, BATS countered that certain order flow 

sending firms today have order flow, which by its very nature, is more 

valuable to some market participants than the flow of other order flow 

sending firms.\20\ BATS notes market makers already retain the 

discretion to pay certain firms non-transparent payment for order flow 

amounts.\21\ BATS asserts that its proposal similarly retains that 

existing discretion for market makers, but provides a mechanism for 

such payments, or at least a portion of such payments, to be provided 

in a transparent fashion to the Directed Order in the form of price 

improvement over the NBBO.\22\ According to BATS, the proposal puts in 

place a structure by which all members can both compete for that flow 

by contributing to price and size discovery for the entire market and 

reward that flow with price improvement above and beyond the NBBO.\23\

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    \20\ See BATS Letter at 6-7.

    \21\ See Notice, supra note 3, at 18283.

    \22\ Id.

    \23\ See BATS Letter at 6-7.

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    Further, BATS notes that BATS Options market makers must enter 

orders that assume the risk of trading with all participants at NBBO, 

and must commit to price improvement over the NBBO without knowing the 

details of the particular order and being guaranteed an allocation.\24\ 

BATS notes that other directed order programs on other exchanges do not 

impose this



[[Page 39956]]



requirement to provide price improvement.\25\ In addition, BATS argues 

that by not providing allocation guarantees, the proposed Directed 

Order program provides incentives to BATS Options market makers as well 

as Options Members to aggressively quote, both at the NBBO and at non-

displayed prices better than the NBBO.\26\

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    \24\ See BATS Letter at 3-4.

    \25\ Id.

    \26\ See Notice, supra note 3, at 18282.

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    Several commenters state that, because Directed Orders on BATS are 

not exposed to all market participants, BATS Options market makers will 

not be motivated to offer more than the minimum amount of price 

improvement ($0.01) to a customer.\27\ In its response letter, BATS 

states that the proposed rule does not cap the price improvement 

opportunities available to Options Members in the price-time priority 

market of BATS Options; rather the proposed rule merely provides a 

minimum amount of price improvement that must be offered to a Directed 

Order.\28\ Another commenter, however, argues that although the BATS 

proposal does not cap price improvement, the lack of competition at the 

non-displayed prices combined with the burden of quoting at the NBBO 

will depress the amount of price improvement offered by BATS Options 

market makers.\29\

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    \27\ See BOX I Letter at 2; NYSE Euronext I Letter at 4 and NYSE 

Euronext II Letter at 4. See also Citadel Letter at 2.

    \28\ See BATS Letter at 6.

    \29\ See ISE II Letter at 2-3.

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    Commenters further argue that the proposal will disincent market 

makers that do not have arrangements with Options Members from 

aggressively quoting and posting liquidity.\30\ According to one of 

these commenters, BATS Options market makers to whom orders are not 

directed would have little to no incentive to quote at the NBBO because 

they would not be rewarded with trade executions, as Directed Orders 

would execute against non-displayed interest one increment better 

rather than the NBBO.\31\ Another commenter also contends that, if the 

proposed rule change is approved, market participants that do not 

receive Directed Orders would be forced to quote less aggressively to 

account for adverse selection because MMPIOs would cherry-pick the most 

desirable order flow from the market with private hidden quotes.\32\ As 

a result, according to this commenter, market liquidity would be 

damaged and average publicly quoted spreads would widen in some options 

contracts, particularly those that trade with wider than average 

spreads.\33\

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    \30\ See BOX I Letter at 1 and Wolverine Letter at 1. See also 

BOX II Letter at 2 (arguing that the high probability that an 

Options Member will designate only one BATS Options market maker to 

receive a Directed Order will mean internalization rates are likely 

to reach 100 percent and have the ``additional effect of 

discouraging competition on the regular order book across all of the 

options market, resulting in further degradation of NBBO spreads, to 

the detriment of all customers.''); ISE Letter at 6 (stating that 

the lack of competition for a Directed Order would result in a 100 

percent execution guarantee for BATS Options market makers, which 

would be a significant departure from Commission policy that limits 

the level of allocation guarantees at 40 percent of the order to 

assure that such guarantees do not remove the incentive for other 

market participants to compete); NYSE Euronext II Letter at 5 

(arguing similarly).

    \31\ See Wolverine Letter at 1.

    \32\ See Citadel Letter at 2.

    \33\ See id.

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    Some commenters argue that the proposal would result in inferior 

executions for customer orders when a BATS Options market maker with a 

MMPIO at the best price is not selected by an Options Member to receive 

its Directed Order.\34\ One of these commenters argues that the 

proposal is inconsistent with the Act because, if two MMPIOs have 

different non-displayed prices, a Directed Order could be directed to 

the MMPIO with the inferior price, resulting in a trade-through of a 

better price that is available to other participants.\35\ BATS 

acknowledges that this factual scenario could be the case, but states 

that in the same way that the Directed Order proposal empowers BATS 

Options market makers to select which order flow providing firms to 

whom they wish to offer price improvement for the customers of that 

firm, the proposal also empowers Options Members to select which market 

making firms they wish to preference.\36\ BATS believes that this is an 

important distinction that provides Options Members with competitive 

opportunities to seek price improvement on customer orders.\37\ 

Further, BATS has amended its proposal to clarify that Options Members 

can enter into arrangements with, and elect to direct an order to, 

multiple market makers.\38\ In such case, the incoming Directed Order 

would execute against the Directed Order market maker with the best 

non-displayed price (assuming that the Directed Order would execute 

against an MMPIO).

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    \34\ See BOX II Letter at 2; Nasdaq I Letter at 1; Nasdaq Letter 

II at 2-3; NYSE Euronext I Letter at 2; and NYSE Euronext II Letter 

at 5.

    \35\ See Nasdaq I Letter at 1. See also NYSE Euronext II Letter 

at 5.

    \36\ See BATS Letter at 4-5.

    \37\ See id.

    \38\ See Amendment No. 2.

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IV. Discussion and Commission Findings



    After careful consideration of the proposal and the comments 

received, the Commission finds that the proposed rule change, as 

amended, is consistent with the requirements of the Act and the rules 

and regulations thereunder applicable to a national securities exchange 

\39\ and, in particular, the requirements of Section 6 of the Act.\40\ 

Specifically, the Commission finds that the proposed rule change, as 

amended, is consistent with Section 6(b)(5) of the Act,\41\ which 

requires, among other things, that the rules of a national securities 

exchange be designed to prevent fraudulent and manipulative acts and 

practices, to promote just and equitable principles of trade, to foster 

cooperation and coordination with persons engaged in regulating, 

clearing, settling, processing information with respect to, and 

facilitating transactions in securities, to remove impediments to and 

perfect the mechanism of a free and open market and a national market 

system, and, in general, to protect investors and the public interest 

and are not designed to permit unfair discrimination between customers, 

issuers, brokers or dealers.

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    \39\ In approving this proposed rule change the Commission has 

considered the proposed rule's impact on efficiency, competition, 

and capital formation. 15 U.S.C. 78c(f).

    \40\ 15 U.S.C. 78f.

    \41\ 15 U.S.C. 78f(b)(5).

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    The Commission notes that the proposed rule change is designed to 

enhance opportunities in the market for BATS Options market makers to 

provide, and Options Members to obtain, price improvement for their 

customer orders. Specifically, to be eligible to trade with a Directed 

Order, the proposal requires a BATS Options market maker to have 

entered a MMPIO with a displayed price equal to the NBB (for sell 

Directed Orders) or the NBO (for buy Directed Orders), as well as a 

non-displayed price at least one cent better than the NBB or NBO, as 

applicable.\42\ Thus, the Directed Order would receive price 

improvement over the NBB or NBO, as applicable. However, as discussed 

above, commenters expressed concern that the lack of exposure of the 

Directed Orders would negatively impact quote competition and deny 

other market participants meaningful opportunities to provide further 

price improvement to a Directed Order.\43\

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    \42\ BATS Rule 21.1(d)(13).

    \43\ See supra notes 14-33 and accompanying text.

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    The Commission has carefully considered the arguments expressed by



[[Page 39957]]



commenters and by the Exchange. The Commission recognizes the concerns 

expressed and the difficult issues involved. The Commission believes 

that order exposure generally is beneficial to options markets in that 

it provides an incentive to options market makers to provide liquidity 

and therefore plays an important role in ensuring competition in the 

options markets.\44\ The Commission also recognizes, however, the 

importance of providing effective opportunities for customer order flow 

in listed options to receive executions at prices better than the NBBO. 

In evaluating the proposal, the Commission has weighed the relative 

merits of each for the options markets.

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    \44\ See Securities Exchange Act Release No. 63955 (February 24, 

2011), 76 FR 11533 at 11540 (March 2, 2011) (SR-ISE-2010-73).

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    On the options markets, specialists and market makers often compete 

for order flow by offering cash or non-cash inducements, known as 

payment for order flow (``PFOF''),\45\ to brokers to send their orders 

to a particular market maker or exchange.\46\ PFOF arrangements are 

prevalent in today's market.\47\ These arrangements likely impact the 

incentives for market makers (or others) to quote aggressively to trade 

with order flow covered by such PFOF arrangements because market 

participants know that the market makers will be able to trade with 

some or all of the captured order flow as long as they match the NBBO 

(whether by displaying quotes that match the NBBO set by others or by 

matching better quotes elsewhere pursuant to mechanisms that provide 

market makers with the opportunity to step-up and trade with orders 

that are exposed for one second).

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    \45\ The Commission has defined PFOF 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).

    \46\ Under a typical payment for order flow arrangement, a 

specialist or market maker offers an order entry firm cash or other 

economic inducement to route its customer orders to that 

specialist's or market maker's exchange because the specialist or 

market maker 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. For further discussion of PFOF 

and its impact on the options markets, see Securities Exchange Act 

Release No. 49175 (February 3, 2004), 69 FR 6124 (February 9, 2004).

    \47\ Reports under Rule 606 of Regulation NMS indicate that 

nearly all retail broker-dealers participate in PFOF arrangements. 

Regulation NMS Rule 606 reports posted by broker-dealers for the 

fourth quarter of 2010 indicate PFOF amounts that generally are 

around $0.30 per contract and can range up to $0.85 per contract.

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    The BATS proposal offers an alternative mechanism to enable market 

makers to compete for order flow by providing better prices directly to 

customers \48\ rather than through payments to the customer's 

broker.\49\ The proposal allows market makers to differentiate between 

orders from traders that are relatively more informed about the short-

term direction of prices (e.g., professional traders) and orders from 

less informed traders (e.g., retail investors). In this way, it may 

enable BATS Options market makers to provide better prices to less 

informed order flow that they otherwise would not be willing or able to 

provide if they had to make those prices available to all incoming 

order flow.\50\ The Commission recognizes that other exchanges have 

adopted different mechanisms that include an order exposure element to 

provide price improvement to customer orders.\51\ The Commission 

questions, however, the extent to which these mechanisms are utilized. 

In the context of this options market structure, the Commission 

believes that the proposal to provide an alternative mechanism for BATS 

options market makers to provide executions for customer orders at 

prices better than the NBBO is consistent with the Act.\52\

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    \48\ See also discussion of Ameritrade Letter on the Prior 

Proposal, supra note 12.

    \49\ The Commission views the BATS proposal as an alternative 

mechanism to PFOF, as it provides a means to benefit customers 

directly through price improvement, rather than the customer's 

broker through PFOF. The Commission is approving the BATS proposal 

in the context of the existence of PFOF arrangements in the options 

markets. Should such arrangements no longer be present in the 

options market, the Commission expects the Exchange to re-evaluate, 

and the Commission may re-evaluate, whether the Directed Order 

program is appropriate.

    The Commission acknowledges, however, that the BATS proposal 

does not preclude an Options Member from separately entering into a 

PFOF arrangement with a BATS Options market maker but believes that, 

even if such arrangements occur, executions occurring pursuant to 

this proposal would receive prices better than the NBBO, thus 

providing a direct benefit to customers in the form of price 

improvement.

    \50\ It is well known in academic literature and industry 

practice that prices tend to move against market makers after trades 

with informed traders, often resulting in losses for market makers. 

See Stoll, H. R., ``The supply of dealer services in securities of 

markets,'' Journal of Finance 33 (1978), at 1133-51; Glosten, L. and 

P. Milgrom, ``Bid ask and transaction prices in a specialist market 

with heterogeneously informed agents,'' Journal of Financial 

Economics 14 (1985), at 71-100; and Copeland, T., and D. Galai, 

``Information effects on the bid-ask spread,'' Journal of Finance 38 

(1983), at 1457-69. Thus, there is a strong economic rationale for 

market makers not providing informed traders price improvement. 

Uninformed investors end up bearing the cost of these market maker 

losses through wider spreads that market makers need to quote to 

uninformed investors due to informed order flow. Id.

    \51\ The Commission notes that market makers on two other 

exchanges are not required to provide price improvement to Directed 

Orders using their price improvement auctions, whereas the BATS 

Directed Order program requires that a BATS Options market maker 

provide price improvement when entering the MMPIO over the NBBO to 

be able to trade with the Directed Order. See BOX Rules, Chapters V, 

Section 18 (The Price Improvement Period) and VI, Section 5(c) 

(Obligations of Market Makers) and ISE Rules 723 (Price Improvement 

Mechanism for Crossing Transactions) and 811 (Directed Orders). The 

Commission further notes that orders are not exposed for possible 

price improvement on other exchanges with ``preferenced'' order 

programs. Under the ``preferenced'' order programs on other 

exchanges, orders are sent to certain market makers, who, if quoting 

at the NBBO at the time the preferenced order is received, are 

guaranteed up to 40% of the order at that price, after resting 

customer orders at that price, if any, are executed. See, e.g., CBOE 

Rule 8.13; ISE Rule 713, Supplementary Material .03; NYSE Amex Rule 

964NY and 964.1NY.

    \52\ In response to comments that, because Directed Orders on 

BATS are not exposed to all market participants, BATS Options market 

makers would not be motivated to offer more than the minimum amount 

of price improvement to a customer, the Commission notes that, under 

the proposed rule, as amended, an Options Member may encourage 

competition for its Directed Orders by submitting them to more than 

one BATS Options market maker that has put that member on its 

eligible customer list, thereby potentially encouraging such market 

makers to provide more than a minimum amount of price improvement.

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    In response to commenters' concerns that the proposal would 

perpetuate a two-tiered market for customers--one market reflecting 

publicly available prices and sizes, and another reflecting a non-

public pool of liquidity available for only certain approved customers 

\53\--the Commission notes that the Act does not prohibit exchange 

members or other broker-dealers from discriminating among customers, so 

long as their activities are not otherwise inconsistent with the 

federal securities laws.\54\ The Commission also notes that the Act 

does not require exchanges to preclude discrimination by broker-

dealers. Indeed, the Commission notes that broker-dealers commonly 

differentiate between customers based on the nature



[[Page 39958]]



and profitability of their business. Further, in general, investors as 

a class tend to have an opinion on the long-term prospects of a 

company, and are less informed about the intraday price movements that 

affect the profitability of market makers. Thus, market makers often 

view less informed order flow as desirable, and there is intense 

competition for this order flow. Allowing market makers to 

differentiate between customers may further encourage market makers to 

provide price improvement to less informed customer order flow, which 

would inure to the benefit of investors. One of the core principles of 

the Act, and Section 6(b)(5) thereof, is the protection of investors. 

Accordingly, the Commission does not believe that it would be 

inconsistent with the Act for the Exchange to provide, under the 

circumstances and facts set forth in this proposal, BATS Options market 

makers the ability to differentiate between customers in providing 

price improvement in the form of MMPIOs.\55\

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    \53\ See supra note 19 and accompanying text.

    \54\ The Commission further notes that it does not agree with 

the comment that an MMPIO is inconsistent with the Quote Rule (see 

supra note 19). An MMPIO is firm and available to all market makers 

at its displayed price. The non-displayed price of a MMPIO, however, 

is not communicated to market participants and thus is not a bid or 

offer for which a market maker is required to be firm pursuant to 

the Quote Rule.

    \55\ See, e.g., Securities Exchange Act Release No. 64097 (March 

18, 2011), 76 FR 16650 (March 24, 2011) (SR-BX-2010-079) 

(eliminating the anonymity of Directed Orders on a permanent basis). 

In its order approving a proposal to remove anonymity from the BOX 

Directed Order process, the Commission stated that it ``does not 

believe that it would be inconsistent with the federal securities 

laws for the Exchange to provide, under the circumstances set forth 

in this proposal, the means for its Market Makers to differentiate 

between customers in providing price improvement or other non-

required advantages to certain customers.''

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    The Exchange has proposed that the Directed Order program operate 

on a six-month pilot basis so that the Commission and the Exchange can 

monitor the effects of the pilot on the markets and investors, and 

consider appropriate adjustments, as necessary. To help the Commission 

and the Exchange evaluate the Directed Order program during the pilot, 

the Exchange proposes to provide to the Commission monthly data 

regarding price improvement and competition in the Directed Order 

program.\56\ In addition, the Exchange has also represented to the 

Commission that it will provide a regulatory study regarding how it 

tests to determine whether the appropriate information barriers are in 

place to protect against an order flow provider giving a market maker 

advance notice of an incoming Directed Order or a BATS Options market 

maker providing information regarding its planned quoting activities or 

details about its MMPIO to an order flow provider. Approving the 

proposal on a pilot basis and requiring submission of monthly data will 

allow the Commission to analyze the Directed Order program and its 

impact, if any, on the marketplace.

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    \56\ See supra Section II for the statistics to be provided by 

the Exchange in monthly reports detailing its ongoing review of the 

pilot.

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V. Solicitation of Comments



    Interested persons are invited to submit written data, views, and 

arguments concerning the foregoing, including whether the proposed rule 

change, as modified by Amendment Nos. 1 and 2, is consistent with the 

Act. Comments may be submitted by any of the following methods:



Electronic Comments



     Use the Commission's Internet comment form http://www.sec.gov/rules/sro.shtml); or

     Send an e-mail to [email protected]. Please include 

File Number SR-BATS-2011-009 on the subject line.



Paper Comments



     Send paper comments in triplicate to Elizabeth M. Murphy, 

Secretary, Securities and Exchange Commission, 100 F Street, NE., 

Washington, DC 20549-1090.



All submissions should refer to File Number SR-BATS-2011-009. This file 

number should be included on the subject line if e-mail is used. To 

help the Commission process and review your comments more efficiently, 

please use only one method. The Commission will post all comments on 

the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 

written statements with respect to the proposed rule change that are 

filed with the Commission, and all written communications relating to 

the proposed rule change between the Commission and any person, other 

than those that may be withheld from the public in accordance with the 

provisions of 5 U.S.C. 552, will be available for Web site viewing and 

printing in the Commission's Public Reference Room, 100 F Street, NE., 

Washington, DC 20549, on official business days between the hours of 10 

a.m. and 3 p.m. Copies of such filing also will be available for 

inspection and copying at the principal office of the Exchange. All 

comments received will be posted without change; the Commission does 

not edit personal identifying information from submissions. You should 

submit only information that you wish to make available publicly. All 

submissions should refer to File Number SR-BATS-2011-009 and should be 

submitted on or before July 28, 2011.



VI. Accelerated Approval of Proposed Rule Change, as Modified by 

Amendment Nos. 1 and 2



    Amendment No. 2 revised the proposed rule change to permit Options 

Members to send Directed Orders to more than one BATS Options market 

maker. Amendment No. 2 also amended the proposed rule change to state 

that if a Directed Order is directed to more than one BATS Options 

market maker, such Directed Order will execute in price/time priority 

based on the non-displayed price of such orders, to the extent the 

Directed Order can execute against any MMPIO. These revisions are 

designed to respond to certain of the commenters' concerns regarding 

competition in the Directed Order program and clarify aspects of the 

proposal. In addition, the Commission notes that the proposed revisions 

may encourage an Options Member to submit a Directed Order to more than 

one BATS Options market maker, thereby potentially encouraging such 

market makers to compete with respect to the amount of price 

improvement they provide. Accordingly, the Commission finds good cause, 

pursuant to Section 19(b)(2) of the Act,\57\ for approving the proposed 

rule change, as modified by Amendment Nos. 1 and 2, prior to the 30th 

day after the date of publication of notice in the Federal Register.

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    \57\ 15 U.S.C. 78s(b)(2).

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VII. Conclusion



    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 

Exchange Act,\58\ that the proposed rule change (SR-BATS-2011-009), as 

modified by Amendment Nos. 1 and 2, be, and hereby is, approved on an 

accelerated basis, for a pilot period ending January 30, 2012.

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    \58\ 15 U.S.C. 78s(b)(2).

    \59\ 17 CFR 200.30-3(a)(12).



    For the Commission, by the Division of Trading and Markets, 

pursuant to delegated authority.\59\

Cathy H. Ahn,

Deputy Secretary.

[FR Doc. 2011-16922 Filed 7-6-11; 8:45 am]

BILLING CODE 8011-01-P