

[Federal Register: March 2, 2006 (Volume 71, Number 41)]
[Notices]               
[Page 10730-10732]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr02mr06-104]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53357; File No. SR-BSE-2005-52]

 
Self-Regulatory Organizations; Boston Stock Exchange, Inc.; 
Notice of Filing of Amendments No. 2, 3, and 4 to Proposed Rule Change 
To Modify the Information Contained in a Directed Order on the Boston 
Options Exchange

February 23, 2006.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on November 25, 2005, the Boston Stock Exchange, Inc. (``BSE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the BSE. On December 
20, 2005, the BSE filed Amendment No. 1 to the proposed rule change.\3\ 
The proposed rule change and Amendment No. 1 were published for comment 
in the Federal Register on December 29, 2005.\4\ The Commission 
received eight comment letters.\5\ In response to the concerns raised 
in the comment letters and discussions with Commission staff, the BSE 
filed Amendments No. 2, 3, and 4 on February 7, 2006, February 15, 
2006, and February 21, 2006, respectively.\6\ The Commission is 
publishing this notice to solicit comments on Amendments No. 4 to the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, the BSE amended the rule text of Chapter 
V, Section 14(e) of the Boston Options Exchange (``BOX'') Rules to 
clarify that the identities of Options Participants that send 
Directed Orders to the Trading Host are not anonymous.
    \4\ See Securities Exchange Act Release Act No. 53015 (December 
22, 2005), 70 FR 77207.
    \5\ See letters to Nancy Morris, Secretary, Commission, from 
Adam C. Cooper, Senior Managing Director & General Counsel, Citadel, 
dated January 11, 2006 and January 12, 2006 (``Citadel Letters''); 
from Michael Simon, General Counsel, International Securities 
Exchange (``ISE''), dated January 19, 2006 (``ISE Letter''); from 
James Gray, Chairman, optionsXpress Holdings, Inc., dated January, 
19, 2006 (``optionsXpress Letter''); from Thomas Peterffy, Chairman, 
and David M. Battan, Vice President, Interactive Brokers Group, 
dated January 24, 2006 (``IB Letter''); from David Chavern, Vice 
President and Chief of Staff, U.S. Chamber of Commerce, dated 
January 25, 2006 (``Chamber of Commerce Letter''); and from Neal L. 
Wolkoff, Chairman & Chief Executive Officer, American Stock 
Exchange, dated February 3, 2006 and February 7, 2006 (``Amex 
Letters'').
    \6\ Amendment No. 2 superseded and replaced the original filing 
and Amendment No. 1. Amendment No. 3 superseded and replaced the 
original filing and Amendments No. 1 and 2. Amendment No. 4 
supersedes and replaces the original filing and all previous 
amendments.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The BSE proposes to amend its rules governing its Directed Order 
process and to modify the information contained in a Directed Order on 
BOX. Below is the text of the proposed rule change. Proposed new 
language is in italics; proposed deletions are in [brackets].
* * * * *

Rules of the Boston Options Exchange Facility

* * * * *

Chapter VI Market Makers

* * * * *

Section 5 Obligations of Market Makers

    (a)-(b) No Change
    (c) When acting as agent for a Directed Order, a Market Maker 
must comply with subparagraphs (i)-(iii) of this Paragraph (c).
    i. A Market Maker shall not receive a Directed Order other than 
through the BOX Trading Host. A Market Maker that receives a 
Directed Order shall not, under any circumstances, reject the 
receipt of the Directed Order from the BOX Trading Host. A Market 
Maker who desires to accept Directed Orders must systemically 
indicate [they are an executing participant] each day [that] and 
whenever the Market Maker [wishes to receive Directed Orders] 
reconnects after disconnection during the day that it is willing to 
accept Directed Orders (``Executing Participant'' or ``EP''). If a 
Market Maker does not systemically indicate that [they are] it is an 
[e]Executing Participant, the BOX Trading Host will not forward any 
Directed Orders to the Market Maker. In such a case, the BOX Trading 
Host will send the order directly to the BOX Book. Prior to 
accepting a Directed Order through the Trading Host, an EP must 
inform BOX of the OFPs from which it has agreed to accept Directed 
Orders through the Trading Host (``Listed OFPs'' or ``LOFPs''). The 
Trading Host will then only send to the EP Directed Orders from 
LOFPs. Such orders will be sent to the EP on an anonymous basis.
    ii.-iii. No change.
* * * * *

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

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

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

1. Purpose
    Amendment No. 4 supersedes and replaces the previous amendments and 
the original filing in its entirety. The original rule filing and 
Amendment No. 1 proposed to clarify that, when Directed Orders are sent 
to a Market Maker, they contain an identifier associated with the firm 
that sent the Directed Order. In response to the original filing, the 
BSE received comments both in support of and opposing the proposal. The 
commenters opposing the proposal argue that the lack of anonymity of 
Directed Orders allows the Market Maker receiving such orders to 
discriminate among the firms for which it will seek to execute Directed 
Orders, and suggest that this selection process is discriminatory, may 
discourage aggressive quoting, and is inconsistent with the Act.\7\ The 
commenter supporting the proposal argues that the lack of anonymity of 
Directed Orders encourages greater levels of price improvement, allows

[[Page 10731]]

Market Makers to protect themselves from predatory firms that engage in 
anti-competitive behavior, and is consistent with the Act.\8\
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    \7\ See Citadel Letters, ISE Letter, Chamber of Commerce Letter, 
optionsXpress Letter, and Amex Letters, supra note 5.
    \8\ See IB Letter, supra note 5.
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    While, as is discussed more fully below, the BSE completely 
disagrees with the core concern expressed by the commenters opposing 
the original proposal, the BSE does believe that it is appropriate to 
amend its proposal to permit EPs to choose the firms from which they 
will accept Directed Orders while providing complete anonymity for 
Directed Orders that are passed on to the Executing Participant 
(``EP'') for possible representation in a PIP auction.\9\ The BSE 
believes that certain commenters have materially mischaracterized the 
Directed Order process. The BSE assumes this mischaracterization is in 
the pursuit of enlisting the Commission to support a market model that 
better suits its firm-centric business approach. In order to more fully 
address this mischaracterization, the BSE starts by first providing a 
brief overview of the Directed Order process. Subsequently, the BSE 
explains why it believes that the identification of the Order Flow 
Provider (``OFP'') in the Directed Order process is not only 
appropriate and consistent with applicable legal standards but also 
would increase investor welfare by expanding, relative to the approach 
suggested by the commenter, the amount of price improvement provided 
investors. Finally, the BSE offers an explanation of the amendment to 
its proposal.
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    \9\ See Securities Exchange Act Release No. 52827 (November 23, 
2005), 70 FR 72139 (December 1, 2005) (SR-PCX-2005-56) (generally 
approving proposal by the Pacific Exchange to ``add a provision that 
requires Users to be given permission by DMMs in order to send a 
Directed Order to that DMM.''); see also Rule 229A(b)(1) of the 
Philadelphia Stock Exchange (generally providing for directed orders 
which are defined as orders that a member organization directs to a 
particular specialist pursuant to an agreement).
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    Under the BSE's Directed Order process, Market Makers on BOX are 
able to handle orders on an agency basis directed to them by OFPs. An 
OFP sends a Directed Order to BOX with a designation of the Market 
Maker to whom the order is to be directed. BOX then routes the Directed 
Order to the appropriate Market Maker. Under Chapter VI, section 
5(c)(ii) of the BOX Rules, a Market Maker only has two choices when he 
receives a Directed Order: (1) Submit the order to the PIP process; or 
(2) send the order back to BOX for placement onto the BOX Book.
    Under Chapter VI, section 5(c)(i) of the BOX Rules, a Market Maker 
who desires to accept Directed Orders must systemically indicate that 
it is an EP each day the Market Maker wishes to receive Directed Orders 
from the BOX Trading Host. Further, the BOX system requires a Market 
Maker to systematically indicate that it is an EP during any day the 
Market Maker has disconnected from the system and seeks to 
reconnect.\10\ If a Market Maker does not systemically indicate that it 
is an EP, then the BOX Trading Host will not forward any Directed 
Orders to that Market Maker. In such a case, the BOX Trading Host will 
send the order directly to the BOX Book.
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    \10\ Telephone conversation between Susie Cho, Special Counsel, 
Jan Woo, Attorney, Division of Market Regulation, Commission, and 
Alden Adkins, General Counsel, BSE, on February 23, 2006.
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    Chapter VI, section 5(c)(i) prohibits a Market Maker from rejecting 
a Directed Order. The BSE wishes to clarify this to mean that upon 
systematically indicating its desire to accept Directed Orders, the BOX 
system prevents a Market Maker that receives a Directed Order from 
either rejecting the receipt of the Directed Order from the BOX Trading 
Host or rejecting the Directed Order back to the OFP who sent it.
    The BSE notes that in all events, whether a Market Maker elects to 
accept Directed Orders or chooses systematically not to accept any 
Directed Orders, its displayed best bid and offer are firm and 
accessible for automatic executions by all order submitters. In other 
words, the Directed Order process is a discretionary service that 
Market Makers may choose to provide or not, above and beyond satisfying 
their core Market Maker obligations of providing continuous two-sided 
firm quotations on a non-discriminatory basis. Just as Market Makers 
may and do choose to provide, or not, other discretionary services, 
such as payment for order flow, the BSE believes that Market Makers 
also may identify the firms for which they may choose to provide such 
discretionary services.\11\
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    \11\ See id.; see also Securities Exchange Act Release No. 47351 
(February 11, 2003), 68 FR 8055 (February 19, 2003) (SR-NASD-2002-
60). As stated in the adopting release, the New York Stock Exchange 
comment letter on the Primex rule proposal argued that 
``participants may selectively trade against agency orders alone by 
using a mechanism to screen out professional orders.'' The Nasdaq 
Stock Market responded ``that this feature ensures that any price 
improvement or enhanced liquidity opportunities be reserved for 
public customers, and not necessarily professional traders who could 
otherwise take advantage of the System's benefits and `pre-empt' the 
ability of a public customer to receive such benefits.'' See 
Securities Exchange Act Release No. 47351 (February 11, 2003), 68 FR 
8055, 8058 (February 19, 2003) (SR-NASD-2002-60). See generally 
Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 
11,388 (March 2, 2000) (stating that the Primary Market Makers and 
Competitive Market Makers on the ISE ``will have the ability to set 
parameters regarding their willingness to trade generally with a 
broker-dealer's proprietary order.'').
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    The BOX system provides Market Makers with information regarding 
the identity of the firms from which a Directed Order originates.\12\ 
The BSE believes that this is not inconsistent with the fact that the 
Directed Order process is a discretionary service and with the 
statute--which does not prohibit broker-dealers from determining which 
customer for whom it will provide a discretionary service (again, as 
used here to mean a service the broker-dealer is not legally required 
to provide at all)--but also is highly desirable. As is true with 
respect to any discretionary service, without some control over the 
OFPs from which Market Makers will accept Directed Orders, Market 
Makers could be expected to provide less of the service. This is 
specifically true with respect to the Directed Order process because 
the customer protections built into the Directed Order process, absent 
the ability to control the OFPs for which it will provide the service, 
could and almost certainly would have the unintended consequences of 
creating an opportunity for Options Participants to engage in abusive 
practices that jeopardize the ability of all Market Makers to price 
improve customer orders. Some Options Participants, including Market 
Makers, could send large numbers of proprietary Directed Orders to 
competitors using strategies that effectively amount to arbitraging the 
PIP auction against previous executions obtained on exchanges that do 
not provide price improvement opportunities. The EP receiving these 
Directed Orders either will end up providing a competitor's order price 
improvement, or yielding priority (if it declines to submit the order 
to the PIP auction) and yet still guarantee his Firm Quote for three 
seconds regardless of whether market prices change during that time. 
The latter outcome is particularly problematic since, at a minimum, the 
EP is forced to forgo whatever time priority he may have had over his 
competitors at the top of the BOX book for the option series in the 
Directed Order. Moreover, the EP is also obligated to freeze his quote 
for three seconds and trade with any unexecuted Directed Order quantity 
(but only if no other Market Maker wants to trade with the Directed 
Order). Essentially this means the EP will trade with the

[[Page 10732]]

declined Directed Order only when no one else wishes to interact with 
the order.
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    \12\ Telephone conversation between Susie Cho, Special Counsel, 
Jan Woo, Attorney, Division of Market Regulation, Commission, and 
Alden Adkins, General Counsel, BSE, on February 23, 2006.
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    The BSE's original proposal addressed this unfair competitive 
situation by enabling EPs to limit Directed Orders from hostile 
competitors and to provide price improvement to the customers for whom 
the Directed Order process was intended. Without this protection, the 
BSE believes that EPs will have to modify their risk assessment and 
therefore give less price improvement to everyone--or perhaps stop 
giving price improvement at all. This would significantly harm the 
retail investors who have benefited from the BOX price improvement 
system since its inception.\13\
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    \13\ Over half of marketable public customer orders sent to BOX 
in 2005 received price improvement--slightly under 3,000 public 
customer orders each day, with an average price improvement per 
contract of over $2.50. Price improvement particularly benefited 
small customer orders, as over 85% of all price improvement was for 
orders of 20 contracts or fewer.
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    The BSE's amended proposal seeks to maintain these very significant 
investor benefits of the original proposal by allowing EPs to provide 
the Exchange a list of firms to which the EP will provide Directed 
Order services. At the same time the BSE also believes that it is 
appropriate to modify the original proposal to prohibit Directed Orders 
delivered to EPs from identifying the firm from which the order comes. 
This would protect the anonymity of individual orders of Options 
Participants and their Directed Orders entered into the Trading Host. 
An EP has no need to know the identity of the Options Participant 
sending a Directed Order on an order-by-order basis once the threat 
from competitors has been mitigated. The BSE believes that the decision 
to price improve, or not, an anonymous Directed Order would be based 
only on objective factors.
2. Statutory Basis
    The Exchange believes that the proposal, as amended, is consistent 
with the requirements of section 6(b) of the Act,\14\ in general, and 
section 6(b)(5) of the Act,\15\ in particular, in that it is designed 
to promote just and equitable principles of trade, to remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system, and protect investors and the public 
interest.
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    \14\ 15 U.S.C. 78f(b).
    \15\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange has neither solicited nor received comments on the 
proposed rule change, as amended.

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether Amendment No. 4 
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 rule-comments@sec.gov. Please include 

File No. SR-BSE-2005-52 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-1090.
    All submissions should refer to File Number SR-BSE-2005-52. 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 inspection 
and copying in the Commission's Public Reference Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of the BSE. 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-BSE-2005-52 and should be submitted on or before March 
23, 2006.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E6-2929 Filed 3-1-06; 8:45 am]

BILLING CODE 8010-01-P
