[Federal Register Volume 77, Number 222 (Friday, November 16, 2012)]
[Notices]
[Pages 68856-68861]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-27819]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-68202; File Nos. SR-Phlx-2012-27; SR-Phlx-2012-54]


Self-Regulatory Organizations; NASDAQ OMX PHLX LLC; Notice of 
Filing of Amendments No. 1, and Order Granting Accelerated Approval for 
Proposed Rule Changes as Modified by Amendments No. 1 Relating to 
Complex Order Fees and Rebates for Adding and Removing Liquidity in 
Select Symbols

 November 9, 2012.

I. Introduction

    On March 1, 2012 and April 23, 2012, NASDAQ OMX PHLX LLC (``Phlx'' 
or ``Exchange'') filed with the Securities and Exchange Commission (the 
``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ and Rule 19b-4 
thereunder,\2\ two proposed rule changes relating to the transaction 
fees for certain complex order (``Complex Order'') transactions.\3\ The 
notice of filing of Phlx-2012-27 was published for comment in the 
Federal Register on March 15, 2012,\4\ and the notice of filing of 
Phlx-2012-54 was published for comment in the Federal Register on May 
4, 2012.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ A Complex Order is any order involving the simultaneous 
purchase and/or sale of two or more different options series in the 
same underlying security, priced at a net debit or credit based on 
the relative prices of the individual components, for the same 
account, for the purpose of executing a particular investment 
strategy. A Complex Order may also be a stock-option order, which is 
an order to buy or sell a stated number of units of an underlying 
stock or exchange-traded fund (``ETF'') coupled with the purchase or 
sale of options contract(s). See Exchange Rule 1080, Commentary 
.08(a)(i).
    \4\ See Securities Exchange Act Release No. 66551 (March 9, 
2012), 77 FR 15400 (SR-Phlx-2012-27) (``Notice I'').
    \5\ See Securities Exchange Act Release No. 66883 (April 30, 
2012), 77 FR 26591 (SR-Phlx-2012-54) (``Notice II'').
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    On April 30, 2012, the Commission suspended the proposals and 
instituted proceedings to determine whether to approve or disapprove 
the proposals.\6\ Following the institution of the proceedings, the 
Commission received a letter from the Exchange in support of its 
proposals.\7\ On September 11, 2012, the Commission issued a notice of 
designation of a longer period for Commission action on the proceedings 
to determine whether to disapprove the proposed rule changes.\8\ On 
October 24, 2012, the Exchange filed Amendment No. 1 to each of the 
proposed rule changes. In the amendments, the Exchange proposed to put 
certain of the fees (for Complex Order executions by Directed 
Participants \9\ and Market Makers) \10\ on a one-year pilot program, 
and stated that the proposed fees would be operative on December 3, 
2012. The Exchange committed to provide publicly available data and 
data analyses of those fees to the Commission during the pilot.\11\ The 
Exchange also represented that, prior to and at the time of a complex 
order transaction, Market Makers, including Directed Participants, are 
unaware of the identity of the contra-party to the transaction. The 
Exchange stated that Rule 707 is intended to prohibit coordinated 
actions between Directed Participants and order flow providers 
(``OFPs''), and that the Exchange proactively conducts surveillance 
for, and enforces against, such violations.\12\
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    \6\ See Securities Exchange Act Release No. 66884 (April 30, 
2012), 77 FR 26595 (May 4, 2012) (``Order Instituting 
Proceedings''). The Order Instituting Proceedings suspended the fees 
adopted in SR-Phlx-2012-27 and SR-Phlx-2012-54. Consequently, these 
fees were in effect for only two months, from March 1, 2012 to April 
30, 2012.
    \7\ See Letter from Joan C. Conley, Senior Vice President and 
Corporate Secretary, Nasdaq OMX, to Elizabeth M. Murphy, Secretary, 
Commission, dated July 26, 2012 (``Response'').
    \8\ See Securities Exchange Act Release No. 67825 (September 11, 
2012), 77 FR 57168 (September 17, 2012).
    \9\ The term ``Directed Participant'' applies to transactions 
for the account of a Specialist, Streaming Quote Trader (``SQT'') or 
Remote Streaming Quote Trader (``RSQT'') resulting from a Customer 
order that is (1) directed to the Specialist, SQT or RSQT by an 
order flow provider, and (2) executed by that Specialist, SQT or 
RSQT electronically on Phlx XL II. See Phlx Fee Schedule at 3.
    \10\ A ``Market Maker'' includes Specialists (see Exchange Rule 
1020) and Registered Options Traders (``ROTs'') (see Exchange Rule 
1014(b)(i) and (ii), which includes SQTs (see Exchange Rule 
1014(b)(ii)(A)) and RSQTs (see Exchange Rule 1014(b)(ii)(B)).
    \11\ See Amendment No. 1 to SR-Phlx-2012-27 and SR-Phlx-2012-54, 
filed October 24, 2012.
    \12\ See Amendment No. 1 to each filing, supra note 11.
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    The Commission received no comment letters on the proposals. This 
order approves the proposed rule changes, as modified by Amendments No. 
1, and approves, as a one-year pilot program, those fees which the 
Exchange proposes to implement on a pilot basis.

II. Description of the Proposals

    The Exchange's first proposal amended Complex Order fees and 
rebates for adding and removing liquidity in its Select Symbols.\13\ 
Specifically, Phlx's proposal: (1) Increased the customer rebate for 
adding liquidity from $0.30 per contract to

[[Page 68857]]

$0.32 per contract; (2) created a new rebate for removing liquidity of 
$0.06 per contract for each contract of liquidity removed by an order 
designated as a customer Complex Order; (3) amended the fee for 
removing liquidity for all participants who are assessed such a fee; 
and (4) created a volume incentive for certain market participants that 
transact significant volumes of Complex Orders on the Exchange.
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    \13\ The Select Symbols are listed in Section I of the Phlx Fee 
Schedule.
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    Phlx's proposal to amend the Fee for Removing Liquidity increased 
the Complex Order Fees for Removing Liquidity for the Directed 
Participant, Market Maker, Firm, Broker-Dealer, and Professional \14\ 
categories of market participants. The fee for Directed Participant 
transactions increased from $0.30 to $0.32 per contract; the fee for 
Market Makers increased from $0.32 to $0.37 per contract; and the fee 
for Firms, Broker-Dealers, and Professionals increased from $0.35 to 
$0.38 per contract.
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    \14\ The term ``Professional'' means any person or entity that 
(i) is not a broker or dealer in securities, and (ii) places more 
than 390 orders in listed options per day on average during a 
calendar month for its own beneficial account(s). See Exchange Rule 
1000(b)(14).
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    The proposal also provided a new volume incentive to Market Makers. 
The Exchange has four categories of Market Makers--Specialists,\15\ 
ROTs,\16\ SQTs \17\and RSQTs\18\--that would all be eligible to receive 
the volume incentive. Under this proposal, if a Market Maker executes 
more than 25,000 contracts of Complex Orders each day in a given month, 
the fees charged for all of that Market Maker's transactions in Complex 
Orders that remove liquidity, both as a Directed Participant and as a 
Market Maker, would be reduced by $0.01 per contract for that month.
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    \15\ A Specialist is an Exchange member who is registered as an 
options specialist pursuant to Exchange Rule 1020(a).
    \16\ A ROT includes a SQT, a RSQT and a Non-SQT ROT, which by 
definition is neither a SQT nor a RSQT, and therefore cannot 
generate and submit quotes electronically. A Registered Option 
Trader is defined in Rule 1014(b) as a regular member of the 
Exchange located on the trading floor who has received permission 
from the Exchange to trade in options for his own account. See 
Exchange Rule 1014(b)(i) and (ii).
    \17\ An SQT is defined in Exchange Rule 1014(b)(ii)(A) as an ROT 
who has received permission from the Exchange to generate and submit 
option quotations electronically in options to which such SQT is 
assigned.
    \18\ An RSQT is defined Exchange Rule in 1014(b)(ii)(B) as an 
ROT that is a member or member organization with no physical trading 
floor presence who has received permission from the Exchange to 
generate and submit option quotations electronically in options to 
which such RSQT has been assigned. An RSQT may only submit such 
quotations electronically from off the floor of the Exchange.
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    In its second proposal, the Exchange did not propose to amend any 
of the fees for the Complex Order Directed Participant and Market Maker 
Fees for Removing Liquidity in Select Symbols. Rather, the Exchange 
provided further justification for the differential between the fees 
paid by Directed Participants and Market Makers.
    As discussed more fully below, in its proposals and in its 
subsequent letter in support of its proposals, the Exchange advanced 
several arguments as to why the proposal to increase the fee for 
removing liquidity for Complex Orders to $0.32 per contract for 
Directed Participants, and to $0.37 per contract for non-directed 
Market Makers, and the corresponding increase in the differential 
between these two fees from $0.02 to $0.05 per contract, was not 
unreasonable or unfairly discriminatory. First, the Exchange stated 
that Directed Participants enter into payment for order flow agreements 
(``PFOF'') with OFPs so that OFPs will direct order flow to them to 
execute against.\19\ According to the Exchange, the reduced fee for 
Directed Participants recognizes the cost that such Market Makers incur 
by entering into such PFOF agreements, and the fact that such 
arrangements bring additional order flow to the Exchange, to the 
benefit of all Exchange market participants. The Exchange also argued 
that Directed Participants have higher quoting obligations, and that 
unlike in the leg markets (i.e., the market for the individual orders 
that make up a complex order) they do not have a guaranteed allocation 
for Complex Orders, and that these facts justify the fees. Second, the 
Exchange stated that the frequency with which Directed Participants 
execute against orders that are directed to them is such that the 
effective fee actually paid by such Market Makers is closer to the 
higher Market Maker rate.\20\ Third, the Exchange stated that the 
proposed increase in the fee differential from $0.02 to $0.05 per 
contract will have a negligible impact on Directed Participants and 
non-directed Market Makers, given the average level of price 
improvement for customer Complex Orders. Fourth, the Exchange argued 
that a higher fee differential currently exists on another options 
exchange that is directly comparable to the Directed Participant/Market 
Maker differential at issue here. Finally, the Exchange argued that, 
given the stated policies of the Commission and applicable case law, 
the Commission should allow competition to determine whether the fees 
are fair and reasonable.
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    \19\ The PFOF agreements at issue here differ from PFOF fees 
charged pursuant to Exchange rules, in that the PFOF agreements here 
were entered into outside of the purview of the Exchange.
    \20\ A Market Maker that has order flow directed to it will be 
assessed the lower Directed Participant fee rate only if it actually 
executes against such order flow; otherwise, it will be assessed the 
higher Market Maker rate.
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    In its order suspending the two proposals and instituting 
proceedings to determine whether to approve or disapprove the 
proposals, the Commission noted several areas of concern. For example, 
the Commission questioned whether discrimination on the basis of 
whether a Market Maker has an off-exchange arrangement to pay an OFP to 
direct its orders to that Market Maker is a ``fair'' basis for 
discrimination among exchange members with respect to the fees charged 
by the Exchange, and whether a flat $0.05 fee differential 
appropriately reflects potential differences that may exist in payment 
for order flow arrangements between Market Makers and OFPs.\21\ The 
Commission also questioned whether the proposed fees and fee 
differential would have an impact on competition, especially as between 
Directed Participants and Market Makers.\22\ Finally, the Commission 
questioned whether the proposed fee changes will affect the quality of 
execution of customer Complex Orders or broader market quality, and, if 
so, how and what type of impact will they have.\23\
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    \21\ See Order Instituting Proceedings, supra note 6, 77 FR 
26598.
    \22\ Id.
    \23\ Id.
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    During the course of the proceedings, the Exchange amended its 
filings to implement the fee for removing liquidity for Directed 
Participants and other Market Makers on a one-year pilot basis, and to 
state that the proposed fees would be operative on December 3, 2012. 
The Exchange also represented that it would provide the Commission with 
certain publicly available data and data analyses, on a monthly basis, 
over the course of the pilot program that would enable the Commission 
to better evaluate the effects of the fee proposals. As part of the 
amendment, the Exchange also represented that, prior to and at the time 
of a complex order transaction, Market Makers, including Directed 
Participants, are unaware of the identity of the contra-party to the 
transaction. The Exchange stated that Rule 707 is intended to prohibit 
coordinated actions between Directed Participants and OFPs, and that 
the Exchange proactively

[[Page 68858]]

conducts surveillance for, and enforces against, such violations.\24\
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    \24\ See Amendment No. 1 to each filing, supra note 11.
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III. Discussion and Commission Findings

    After careful consideration, and as discussed below, the Commission 
finds that the proposed rule changes are consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange. In particular, the 
Commission finds that the proposals are consistent with Section 6(b)(4) 
of the Act, which requires that the rules of a national securities 
exchange ``provide for the equitable allocation of reasonable dues, 
fees, and other charges among its members and issuers and other persons 
using its facilities;''\25\ Section 6(b)(5) of the Act, which requires, 
among other things, that the rules of a national securities exchange 
not be ``designed to permit unfair discrimination between customers, 
issuers, brokers, or dealers;''\26\ and Section 6(b)(8) of the Act, 
which requires that the rules of a national securities exchange ``not 
impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of [the Exchange Act].''\27\ The Commission 
has also considered, pursuant to Section 3(f) of the Act, the 
proposals' impact on efficiency, competition and capital formation.\28\
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    \25\ 15 U.S.C. 78f(b)(4).
    \26\ 15 U.S.C. 78f(b)(5).
    \27\ 15 U.S.C. 78f(b)(8).
    \28\ See 15 U.S.C. 78c(f).
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    Phlx argues in part that the Commission should rely on competitive 
forces to determine whether the proposed fees are reasonable and not 
unfairly discriminatory. Phlx states that competition should determine 
fee changes, noting that the ``Congress directed that exchanges' fee 
changes be deemed immediately effective for the expressed purpose of 
promoting price competition between markets.'' \29\ In support of this 
argument, Phlx states that the Commission has ``a statutory duty to 
promote competition, including price competition.'' \30\ Phlx also 
notes that the DC Circuit Court of Appeals has ``blessed'' the 
Commission practice of relying on competitive forces, where possible, 
to assess the reasonableness of proposed rules,\31\ and that 
intervention here would contravene the Commission's ``stated policy'' 
in this respect.\32\
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    \29\ See Response, supra note 7, at 12.
    \30\ Id. at 12.
    \31\ Id. at 11 (citing NetCoalition v. SEC, 615 F.3d 525 (DC 
Cir. 2010)).
    \32\ Id. at 10.
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    Phlx represents that the options markets operate in an intensely 
competitive environment, and that it and the other options exchanges 
are engaged in an intense competition on price (and other dimensions of 
competition) to attract order flow from directed and other order flow 
providers.\33\ As an example, the Exchange notes that it and the Nasdaq 
Options Market (``NOM,'' a sister exchange) have modified options 
trading fees monthly or even bi-monthly to attract new order flow, 
retain existing order flow, and regain order flow lost to competitor's 
price cuts.\34\ Phlx further states that price incentives are the 
essence of competition, in that they encourage market participants to 
provide attractive offerings to consumers, they benefit market 
participants who trade on the Exchange, and, in turn, they benefit 
consumers who enjoy greater price transparency and execution at lower 
prices.\35\
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    \33\ Id. at 1, 2, 11.
    \34\ Id. at 11. The Exchange represents that in 2011 it and NOM 
filed 71 execution fee changes and all of the options exchanges 
together filed 173 fee changes (excluding market data, connectivity, 
colocation, and other fees). Id.
    \35\ Id. at 1-2.
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    Phlx asserts that, in vibrant markets such as the options markets, 
participants who view one pricing scheme as unpalatable are free to 
move to another market or markets with favorable pricing.\36\ Phlx 
states that, given the competitive nature of the options markets, no 
one exchange has sufficient market power to ``raise prices for 
competitively-traded options in an unreasonable or unfairly 
discriminatory manner in violation of the* * * Act.'' \37\ According to 
Phlx, it is the member firms that have market power, as these market 
participants control the order flow that the options markets compete to 
attract.\38\
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    \36\ Id. at 12.
    \37\ Id. at 12.
    \38\ Id. at 12.
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    The Commission disagrees with the Exchange's assertion that the 
existence of competition alone is adequate to determine whether the 
fees are reasonable, not unfairly discriminatory, and an equitable 
allocation of fees among members under the Exchange Act. The 
Commission's market-based approach to evaluating whether certain market 
data fees are consistent with the Exchange Act incorporates two 
parts.\39\ First, the Commission examines whether the exchange making 
the proposal was subject to significant competitive forces in setting 
the terms of its proposal, including the level of any fees. If the 
exchange was subject to significant competitive forces in setting the 
terms of a proposal, the Commission will approve the proposal unless it 
determines that there is a substantial countervailing basis to find 
that the terms nevertheless fail to meet an applicable requirement of 
the Exchange Act or the rules thereunder. The Commission has cited an 
unfair or unreasonably discriminatory proposal as an example of one 
such countervailing basis.
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    \39\ See Securities Exchange Act Release No. 59039 (December 2, 
2008), 73 FR 74770 (December 9, 2008) (SR-NYSEArca-2006-21); vacated 
and remanded, NetCoalition v. SEC, 615 F.3d 525 (DC Cir. 2010)). In 
the NetCoalition decision, the court held that the Commission's 
market-based approach to the market data fees in question was 
consistent with the Exchange Act, but reversed because the 
Commission had not adequately explained how competition would 
adequately constrain pricing in the particular case before it and 
that the record in the case did not contain sufficient evidence to 
support the Commission's conclusions.
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    Applying this approach to the Exchange's proposal, the Commission 
finds under the first part of the analysis that the Exchange was 
subject to significant competitive forces in setting the terms of its 
proposal. There currently are ten registered national securities 
exchanges that trade listed options. The Commission has previously 
found that there is significant competition for order flow in the 
options markets.\40\ The Exchange provided representations and data 
supporting the existence of intense competition for order flow among 
the options exchanges. In particular, the Exchange stated that the 
trading of options is a highly competitive environment, and that the 
ability to attract order flow is driven largely by price 
competition.\41\ The Exchange also stated that member firms control the 
order flow that options markets compete to attract, and that exchange 
members, rather than the exchanges, drive competition.\42\ The Exchange 
produced data showing the market share, based on contract volume, among 
the options exchanges, which, as of 2012, ranged from approximately 
less than 1% to 22% for equity options.\43\ Similarly, monthly volume 
data published by the

[[Page 68859]]

Options Clearing Corporation indicates that market share for equity 
options for September 2012 ranged from 0.70% (for NOBO) to 22.97% (for 
Phlx).\44\ Further, six of the ten options exchanges have rules that 
provide for the trading of complex orders.\45\ The Exchange produced 
data regarding market share among the options exchanges for complex 
orders on a monthly basis from November 2011 to June 2012. For June 1, 
2012, the Exchange stated that the market share for complex orders 
ranged from 3.39% for NYSE Arca, which had 74,486 complex order trades, 
to 43.79% for ISE, which had 961,040 complex order trades.\46\ 
Moreover, the volume for complex orders has been increasing over the 
past few years.\47\ Further, the Commission's finding is based on the 
representation by the Exchange that the fees at issue apply only to the 
Select Symbols, which are all equity options that are able to be listed 
and traded on more than one options exchange, and are therefore subject 
to competition among the market for order flow.\48\
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    \40\ See Securities Exchange Act Release No. 61317 (January 8, 
2010), 75 FR 2915 (January 19, 2010) (SR-ISE-2009-103) (finding that 
the exchange was subject to significant competitive forces in 
setting the terms of its proposal, including fees, and noting that 
``the Exchange has a compelling need to attract order flow to 
maintain its share of trading volume, imposing pressure on the 
Exchange to act reasonably in establishing fees for these data 
offerings'').
    \41\ See Response, supra note 7, at 11.
    \42\ Id. at 12.
    \43\ See Response, supra note 7, at 12.
    \44\ See Options Clearing Corporation, Options Volume by 
Exchange, September 2012, at http://www.optionsclearing.com/webapps/exchange-volume.
    \45\ See C2 Rule 6.13; CBOE Rules 6.42, 6.45, 6.53C; ISE Rule 
722; NYSE Arca Rules 6.62(e), 6.91; NYSE MKT Rules 900.3NY(e), 
963NY, 980NY.
    \46\ See Phlx Supporting Data, at http://www.sec.gov/comments/sr-phlx-2012-27/phlx201227-2.pdf. Similarly, market share for 
complex orders in November 2011 ranged from 1.64% for C2, which had 
33,406 trades, to 39.50% for ISE, which had 804,845 trades. Market 
share for complex orders in February 2012 ranged from 2.78% for NYSE 
Arca, which had 69,498 trades, to 37.97% for ISE, which had 950,368 
trades.
    \47\ See Complex Orders Surge, Traders Magazine, March 2012 
(noting increase in use of customer orders by customers at one 
broker-dealer in 2011); see also BATS February 2012 Options Market 
Update, at http://www.batstrading.com/resources/fee_schedule/2012/BATS-February-2012-US-Market-Update.pdf (noting that more volume is 
being done through complex strategies, and that volume in the 
complex order book has increased).
    \48\ See Response, supra note 7, at 11.
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    Under the second part of the analysis, the Commission does not at 
this time find that there is a substantial countervailing basis to find 
that the terms of the fees and fee differential fail to meet the 
requirements of the Exchange Act or the rules thereunder. The 
Commission notes that it received no comments in opposition to the 
proposed rule changes. The fees for removing liquidity as proposed 
distinguish between Directed Participants and all other Market Makers 
(or other members), and would provide the Directed Participants a lower 
fee than other Market Makers when the Directed Participants interact 
with order flow that has been directed to them. The Exchange argues in 
part that Directed Participants that execute against order flow in the 
complex market that has been directed to them do not have a 40% 
guaranteed allocation, unlike in the leg market,\49\ and that the 
reduced fee for Directed Participants is an attempt to confer an 
additional benefit on Directed Participants for the value they provide 
in bringing order flow to the Exchange. The Exchange also argues that 
increased order flow provides better execution quality on the Exchange 
because customers enjoy greater price transparency and executions at 
lower prices, and that Market Makers to whom order flow is directed 
still must compete with other Exchange participants to interact with 
that order flow to receive the benefits of such arrangements.\50\ 
According to the Exchange, this increased order flow, and corresponding 
greater execution quality, benefits all market participants.\51\
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    \49\ See Response, supra note 7, at 17. Orders in the leg market 
are allocated pursuant to Exchange Rule 1014. Specifically, Directed 
Orders that are executed electronically are allocated first to 
customer limit orders resting on the limit order book at the 
execution price. For orders involving Directed Specialists, the 
contracts remaining in the Directed Order, if any, shall be 
allocated automatically as follows: The Directed Specialist shall be 
allocated a number of contracts that is the greater of: (a) The 
proportion of the aggregate size at the NBBO associated with such 
Directed Specialist's quote, SQT and RSQT quotes, and non-SQT ROT 
limit orders entered on the book at the disseminated price 
represented by the size of the Directed Specialist's quote; (b) the 
Enhanced Specialist Participation as described in Rule 1014(g)(ii); 
or (c) 40% of the remaining contracts. See Exchange Rule 
1014(g)(viii).
    For orders involving Directed RSQTs or SQTs, the contacts 
remaining in the Directed Order, if any, shall be allocated 
automatically as follows: The Directed RSQT or SQT shall be 
allocated a number of contracts that is the greater of the 
proportion of the aggregate size at the NBBO associated with such 
Directed SQT or RSQT's quote, the specialist's quote, other SQT and 
RSQT quotes, and non-SQT ROT limit orders entered on the book via 
electronic interface at the disseminated price represented by the 
size of the Directed RSQT or SQT's quote at the NBBO, or 40% of the 
remaining contracts. See Exchange Rule 1014(g)(viii).
    \50\ See Notice I, supra note 4, at 15404 and Response, supra at 
note 7, at 2.
    \51\ See Notice I, supra note 4, at 15404.
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    The Commission has previously approved as consistent with the Act 
rules of exchanges that provide directed Market Makers a 40% guaranteed 
allocation when they interact with directed order flow, based upon 
their status as directed Market Makers.\52\ Likewise, pursuant to the 
proposals at issue here, Directed Participants on Phlx would be charged 
a lower fee when they interact with order flow directed to them, based 
on their status as Directed Participants.
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    \52\ See, e.g., Securities Exchange Act Release No. 51759 (May 
27, 2005), 70 FR 32860 (June 6, 2005) (order approving SR-Phlx-2004-
91). In that order, the Commission noted that the Directed 
Participant would have to be quoting at the NBBO at the time the 
directed order was received to capitalize on the guarantee, and that 
Directed Participants have greater quoting obligations than other 
Phlx Market Makers that cannot be Phlx Directed Participants. Id.
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    When approving the proposals that provided a guaranteed allocation 
to directed market makers, the Commission found that the guaranteed 
allocation for directed market makers would not affect the incentives 
of the trading crowd to compete aggressively for orders based on 
price.\53\ Here, the Commission believes that the potential impact of a 
guaranteed allocation on competition may be distinguished from the 
potential impact of the reduced transaction fee on competition. 
Specifically, the guaranteed allocation does not provide directed 
market makers an explicit subsidy--in the form of lesser per contract 
fees--over other market makers that are competing to execute against 
the same order flow. Rather, the guaranteed allocation scheme allocates 
portions of orders to other Market Makers who are at the same price as 
the directed market maker, thus protecting the incentive of other 
market makers to compete with directed market makers on price. In 
contrast, assessing a lesser transaction fee on Directed Participants 
than other Market Makers when the Directed Participants interact with 
order flow directed to them may allow Directed Participants to execute 
against Complex Orders at more aggressive prices than other market 
makers, which may reduce the incentive and ability of such other market 
makers to compete with Directed Participants on price.
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    \53\ Id. See also Securities Exchange Act Release No. 34606 
(August 26, 1994), 59 FR 45741 (September 2, 1994) (SR-Phlx-94-12) 
(approving 40% specialist guarantee).
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    The Commission has carefully considered the potential impact of the 
fees for removing liquidity on Directed Participants and other Market 
Makers and the $0.05 fee differential on competition between Directed 
Participants and other Market Makers that are competing to execute 
against the same order flow, and on the extent of price improvement 
provided to directed customer Complex Orders. The data provided by Phlx 
does not show any statistical significant adverse impact of the 
proposed fee and fee differential on the competitiveness of the market 
for directed customer Complex Orders on Phlx, or the extent of price 
improvement for directed customer Complex Orders.\54\
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    \54\ For purposes of studying the competitive impact of the fees 
for Directed Participants and other Market Makers, Phlx provided 
data on the rate of interaction with directed customer Complex 
Orders by both Directed Participants and non-directed Market Makers. 
This data was provided, on a weekly basis, for the twelve months 
prior to the time the suspended fees were in effect, in addition to 
the two months the suspended fees were in place. Phlx also provided 
data on rates of price improvement for directed customer Complex 
Orders that received price improvement by both Directed Participants 
and non-directed markers. This data was provided for the four months 
prior to the time the suspended fees were in effect, in addition to 
the two months the suspended fees were in place. Phlx also produced 
data on the percentage of directed and non-directed customer Complex 
Orders that received price improvement, and the average price 
improvement for such orders. This data was provided for the four 
months prior to the time the suspended fees were in effect, in 
addition to the two months the suspended fees were in place.
    With respect to rates of customer Complex Order interaction, for 
the period prior to the introduction of the new fees (March 2011-
February 2012), the average order interaction by Directed 
Participants was 14.98%. For March and April 2012, when the lower 
Directed Participant (as compared to the fee assessed to other 
Market Makers) fee was in effect, the statistics show that order 
interaction by Directed Participants averaged 14.02% and 15.64%, 
respectively. These figures reflect the rates of Complex Order 
interaction as averaged among Directed Participants, i.e., the rate 
of Complex Order interaction for any given Directed Participant 
could, in fact, be much higher.
    With respect to price improvement data, Phlx produced data for 
directed customer Complex Orders receiving price improvement, 
showing the breakdown by contra side participant type, and the 
average amount of price improvement for such order flow, also by 
contra side participant type. This data was produced for November 
2011 to May 2012, using the week before the standard expirations in 
each month. The data that has been submitted shows that, for 
directed customer Complex Orders that received price improvement, 
Directed Participants interacted with those orders 7.8% of the time, 
and provided average price improvement of $7.90 per contract, during 
the time that the suspended fees were not in effect (November 2011-
February 2012, and May 2012), and 11.8% of the time, with an average 
price improvement amount of $4.70 per contract, during the time that 
the suspended fees were in effect (March-April 2012). For directed 
customer Complex Orders that received price improvement, other 
Market Makers interacted with those orders 86.74% during the time 
that the suspended fees were not in effect (November 2011-February 
2012, and May 2012) and 7.8% of the time during the time that the 
suspended fees were in effect (March-April 2012), and provided 
average price improvement of $6.14 and $5.15 per contract, 
respectively, for the same respective time periods.
    Phlx also produced data showing the percentage of directed and 
non-directed customer Complex Orders that received price 
improvement, and the average amount of price improvement. This data 
was produced for November 2011 to May 2012, using the week before 
the standard expirations in each month. The data that has been 
submitted shows that non-directed customer Complex Orders received 
price improvement 17.2% of the time while the suspended fees were 
not in effect (November 2011-February 2012, and May 2012), with an 
average price improvement of $3.29 per contract. During the time the 
suspended fees were in effect (March-April 2012), non-directed 
Customer Complex orders received price improvement 13% of the time, 
with an average price improvement of $3.39 per contract. Directed 
customer Complex Orders received price improvement 29.6% of the time 
while the suspended fees were not in effect (November 2011-February 
2012, and May 2012), with an average price improvement of $6.26 per 
contract. During the time the suspended fees were in effect (March-
April 2012), directed Customer Complex orders received price 
improvement 30.5% of the time, with an average price improvement of 
$5.10 per contract.
    In providing this data, Phlx used a definition of price 
improvement that compared the execution price with the limit price 
of the incoming order. In the data to be provided by Phlx as part of 
the pilot, Phlx will measure price improvement by comparing the Phlx 
best bid or offer at the time of the incoming order to the execution 
price of the order.

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[[Page 68860]]

    However, the suspended fees that are at issue were only in place 
for two months and thus were only analyzed over that period.\55\ Phlx 
has filed an amendment to its filing to, among other things, specify 
that the portion of the proposed rule change relating to execution fees 
for Complex Orders for Directed Participants and other Market Makers, 
and the accompanying $0.05 fee differential, will be operative on a 
one-year pilot basis, and that such fees will be operative on December 
3, 2012. Phlx also has committed to provide the Commission, on a 
monthly basis, with publicly available data and data analyses studying 
the impact of the fees for removing liquidity for complex orders for 
Directed Participants and other Market Makers upon inter and intra-
market competition, and upon market quality. The Exchange has 
represented that it would provide such information as the Commission 
may request regarding this fee pilot, including information with 
respect to rates of order interaction by Directed Participants and 
Market Makers with Customer Complex Orders and rates of price 
improvement for Complex Orders.
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    \55\ See supra note 6.
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    This data and analysis will allow the Exchange and the Commission 
to further evaluate during the course of the pilot program the impact 
of the fees for removing liquidity for Directed Participants and other 
Market Makers and the $0.05 fee differential on competition between 
Directed Participants and other Market Makers and the extent of price 
improvement for Complex Orders over a longer time period with a larger 
data set.\56\ For these reasons, the Commission finds that the proposed 
rule changes, each as modified by Amendment No. 1, are consistent with 
the Act. The Commission's finding takes into account that Directed 
Participants are subject to heightened quoting obligations compared to 
other Market Makers that are not Directed Participants,\57\ and that 
the fact that whether a customer Complex Order is a directed order or 
not is not known to any Market Maker, including Directed Participants, 
prior to execution.\58\
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    \56\ See Securities Exchange Act Release No. 66278 (January 30, 
2012), 77 FR 5590 (SR-BX-2011-046) (approving a fee change to the BX 
Price Improvement Period (``PIP'') upon finding, in part, that the 
data provided by the exchange did not ``suggest any significant 
adverse impact of the proposed PIP fee change on the competitiveness 
of the PIP auction or the extent of price improvement for orders 
executed in the PIP in those series.'').
    \57\ The Commission recognizes that, given the structure of the 
Complex Order market on Phlx, there currently are no quoting 
obligations on Phlx specific to Complex Orders. However, quotations 
in the leg markets are relevant to the Complex Order market, as 
Complex Orders are priced based on the leg markets, and executions 
on the Complex Order market must take into account the prices in the 
leg markets. Additionally, Directed Participants must be at the best 
price for a complex order to execute against the Complex Order.
    \58\ Phlx Rule 707 prohibits Directed Participants and order 
flow providers from coordinating actions involving Directed Orders. 
See also Securities Exchange Act Release No. 51759 May 27, 2005), 70 
FR 32860 (June 6, 2005) (SR-Phlx-2004-91) (noting the applicability 
of Rule 707 to this scenario). Thus, an order flow provider cannot 
let a Directed Participant know when it is sending a directed 
customer Complex Order to Phlx, or that it has such an order resting 
on Phlx's Complex Order book. In Amendment No. 1 to the proposals, 
Phlx noted that Rule 707 is intended to prohibit coordinated actions 
between Directed Participants and OFPs, and that the Exchange 
proactively conducts surveillance for, and enforces against, such 
violations. See Amendment No. 1 to SR-Phlx-2012-27 and SR-Phlx-2012-
54, supra note 11.
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    In its original filing, the Exchange also pointed to the existence 
of non-exchange sponsored PFOF arrangements as a basis for the fees and 
fee differential. Specifically, Phlx argued that the fee differential 
is fair, equitable and not unfairly discriminatory because it is 
intended ``to * * * reflect the increased costs that are incurred by 
such Market Makers that enter into order flow arrangements at a cost 
and without the benefit of a guaranteed allocation.'' \59\
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    \59\ See Notice I, 77 FR 15402.
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    In support of its argument, Phlx has represented that it is aware 
that non-exchange-sponsored PFOF arrangements exist, and that the rates 
paid by Market Makers under these arrangements, in many cases, ``exceed 
[Phlx's] own exchange-sponsored payment for order flow fee and also 
exceed the rebates that [Phlx] provides for adding or removing 
liquidity from the exchange.'' \60\ However, Phlx also represented that 
it ``does not compile data on the exact prices that Market Makers pay 
third-party order flow providers for directed order flow * * *.'' \61\ 
Phlx has not produced any data with respect to non-exchange-sponsored 
payment for order flow arrangements, and has represented to Commission 
staff that it does not have such data.\62\
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    \60\ See Response, supra note 7, at 14.
    \61\ Id.
    \62\ Phlx did provide links to the Web sites of two order flow 
providers, Interactive Brokers and Wedbush. The Interactive Brokers 
link generally describes its PFOF practices, and states that it 
receives PFOF payments from Timber Hill ``consistent with SEC-
approved'' PFOF plans. Since the Commission does not approve non-
exchange-sponsored PFOF arrangements, this sentence presumably 
refers to exchange-sponsored PFOF payments, which are not relevant 
here. The Wedbush link notes that PFOF payments with respect to the 
options exchanges range from $0-$0.75 per contract.

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[[Page 68861]]

    The Commission does not believe that this argument provides a 
reasonable basis to find that the fees and fee differential are 
consistent with the Act. As outlined above, pursuant to this argument, 
Phlx would be setting its fees, and discriminating among market 
participants, based on the existence of non-exchange sponsored PFOF 
arrangements. The record, however, does not contain any representations 
regarding the amounts of payments made by Directed Participants 
pursuant to such arrangements or whether such payments are made, 
whether these off-exchange PFOF arrangements are standardized, and 
whether the terms and amounts are the same between different OFPs and 
Directed Participants. As such, the Exchange has not substantiated the 
details of such off-exchange PFOF arrangements. The Commission believes 
it is likely that the terms of such arrangements could vary 
considerably between different Directed Participants and OFPs. 
Essentially, pursuant to this argument, Phlx could be discriminating in 
its fees for a specified amount based on payments potentially made off-
exchange that may vary widely. The Commission therefore does not 
believe that this argument provides a basis to support a finding that 
the fees and fee differential are reasonable, equitably allocated, and 
not unfairly discriminatory. Nevertheless, for the reasons discussed 
above, the Commission finds that the proposed rule changes are 
consistent with the Act.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. 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 email to [email protected]. Please include 
File Numbers SR-Phlx-2012-27 and SR-Phlx-2012-54 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 Numbers SR-Phlx-2012-27 and SR-
Phlx-2012-54. This file number should be included on the subject line 
if email 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 10:00 a.m. and 3:00 p.m. Copies of 
the 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 Numbers SR-Phlx-2012-27 and SR-Phlx-2012-54 and should be 
submitted on or before December 7, 2012.

V. Accelerated Approval of Proposed Rule Changes, as Modified by 
Amendments No. 1

    Amendments No. 1 revised the proposed rule changes to, among other 
things, specify that the portion of the proposed rule change relating 
to fees for removing liquidity for Complex Orders for Directed 
Participants and other Market Makers, and the accompanying $0.05 fee 
differential, will be operative on a one-year pilot basis, and that 
such fees would be operative on December 3, 2012. Phlx also committed 
to provide the Commission, on a monthly basis, with publicly available 
data and data analyses studying the impact of the fees for removing 
liquidity for complex orders for Directed Participants and other Market 
Makers upon inter and intra-market competition, and upon market 
quality. The Exchange represented that it would provide such 
information as the Commission may request regarding this fee pilot, 
including information with respect to rates of order interaction with 
Customer Complex Orders and rates of price improvement. Receiving data 
and analysis from the Exchange during the duration of the pilot period 
will allow the Commission (and the Exchange) to continue to assess the 
impact, if any, of the proposed rule changes during the pilot period. 
Accordingly, the Commission finds good cause, pursuant to Section 
19(b)(2) of the Act,\63\ for approving the proposed rule changes, as 
modified by Amendments No. 1, prior to the 30th day after the date of 
publication of notice in the Federal Register.
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    \63\ 15 U.S.C. 78s(b)(2).
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VI. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule changes, as modified by Amendments No. 1, are consistent with the 
Act and the rules and regulations thereunder applicable to a national 
securities exchange, and, in particular, with Sections 6(b)(4), 
6(b)(5), and 6(b)(8) of the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\64\ that the proposed rule changes (SR-Phlx-2012-27 and SR-Phlx-
2012-54), as modified by Amendments No. 1, be, and hereby are, 
approved. With respect to the fees for executions of Complex Orders by 
Directed Participants and Market Makers, such fees are approved on a 
one-year pilot basis, with such fees being operative on December 3, 
2012.
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    \64\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\65\
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    \65\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2012-27819 Filed 11-15-12; 8:45 am]
BILLING CODE 8011-01-P