
[Federal Register: July 9, 2010 (Volume 75, Number 131)]
[Proposed Rules]               
[Page 39625-39628]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09jy10-12]                         


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Part II





Securities and Exchange Commission





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17 CFR Part 242



Elimination of Flash Order Exception From Rule 602 of Regulation NMS; 
Proposed Rule


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-62445; File No. S7-21-09]
RIN 3235-AK40

 
Elimination of Flash Order Exception From Rule 602 of Regulation 
NMS

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule; reopening of comment period.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
reopening the period for public comment on a proposal to eliminate the 
flash order exception with respect to listed options from Rule 602 of 
Regulation NMS under the Securities Exchange Act of 1934 (``Exchange 
Act''). The proposal originally was published in Securities Exchange 
Act Release No. 60684 (September 18, 2009), 74 FR 48632 (September 23, 
2009).

DATES: Comments should be received on or before August 9, 2010.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File No. S7-21-09 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

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 No. S7-21-09. This file number 
should be included on the subject line if e-mail is used. To help us 
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/proposed.shtml). Comments 
are also 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. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Theodore S. Venuti, Special Counsel, 
at (202) 551-5658, Arisa Tinaves, Special Counsel, at (202) 551-5676, 
Gary M. Rubin, Attorney, at (202) 551-5669, Division of Trading and 
Markets, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: 

I. Introduction

    Rule 602 of Regulation NMS \1\ and Rule 301(b) of Regulation ATS 
\2\ require exchanges and alternative trading systems (``ATSs''), 
respectively, to provide their best-priced quotations to the 
consolidated quotation data that is widely disseminated to the 
public.\3\ In September 2009, the Commission proposed to amend Rule 
602(a)(1)(i)(A) to eliminate an exception for the use of flash orders 
with respect to trading in both NMS stocks and listed options 
(``Proposal'').\4\ The exception applies to quotations that are 
executed immediately after communication, or cancelled or withdrawn if 
not executed immediately after communication. Flash orders are exposed 
to some market participants for a brief period of time (generally less 
than one second), but are not included in the consolidated quotation 
data pursuant to the Rule 602 exception. Moreover, flash orders 
generally are immediately executable at prices that equal (or ``lock'') 
the best displayed quotations on the contra side of the market, yet the 
orders are flashed rather than being immediately routed away to another 
market to execute against the quotations that establish the best 
prices.
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    \1\ 17 CFR 242.602.
    \2\ 17 CFR 242.301(b).
    \3\ Consolidated quotation data captures the best-priced 
quotations from exchanges, ATSs, and other trading centers for 
listed cash equities and options. This core data for a security is 
consolidated and distributed to the public by a single central 
processor pursuant to Commission rules.
    \4\ Securities Exchange Act Release No. 60684 (September 18, 
2009), 74 FR 48632 (September 23, 2009) (``Proposing Release''). The 
Proposing Release contains a detailed description of a flash order. 
See Proposing Release at 48633-48634.
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    With respect to listed options, the Commission is reopening the 
comment period to invite additional comment on the issues set forth in 
this release, as well as any other issues that the public wishes to 
address with respect to the Proposal as it would affect the listed 
options markets.
    Of the 93 commenters that submitted views on the Proposal to the 
Commission, 67 generally supported the Proposal, 12 generally opposed 
the Proposal, and another 9 opposed the Proposal specifically for 
trading in listed options.\5\ Supporters generally believed that 
eliminating the flash order exception would address the potential for 
two-tiered access to information concerning the best available prices 
for a security, encourage the public display of liquidity, and enhance 
the fairness of the markets for investors.\6\ Those opposing the 
Proposal generally believed that flash orders can benefit investors by 
attracting additional liquidity and by helping to minimize trading 
fees.\7\
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    \5\ In addition to the supporting and opposing commenters, five 
commenters neither supported nor opposed the Proposal. Copies of 
comments received on the Proposal are available on the Commission's 
Internet Web site, located at http://www.sec.gov/comments/s7-21-09/
s72109.shtml, and in the Commission's Public Reference Room at its 
Washington, DC headquarters.
    \6\ Supporting commenters included individuals, industry groups, 
exchanges, and broker-dealers.
    \7\ Opposing commenters included 6 individuals, exchanges, an 
electronic communication network (``ECN''), a broker-dealer, and two 
academics.
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    Specifically with respect to listed options, those opposing the 
Proposal focused on the differences between the cash equity and the 
listed options markets. For example, four commenters addressing the 
Proposal for listed options emphasized that there is no regulatory cap 
on the fees charged by listed options exchanges to access their best 
displayed quotations,\8\ in contrast to access fees in the cash equity 
markets which generally are capped at $0.003 cents per share by Rule 
610(c) of Regulation NMS. Moreover, a commenter emphasized that access 
fees are significantly higher in the options markets than in the cash 
equity markets, on both an absolute basis ($0.003 per share for cash 
equities and $0.0045 (per share equivalent) for options on one 
exchange) and a percentage basis (0.0176% of the average stock price 
for retail investors and 0.266% of the average option price for retail 
investors).\9\ Commenters also were concerned that, in the absence of a 
fee cap for options, elimination of the flash

[[Page 39627]]

order exception could lead to even higher access fees.\10\
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    \8\ Letter from John C. Nagel, Managing Director and Deputy 
General Counsel, Citadel Investment Group, Inc. (``Citadel'') dated 
November 20, 2009 (``Citadel Letter'') at 2; Letter from Peter 
Bottini, EVP Trading and Customer Service, and Hillary Victor, 
Associate General Counsel, optionsXpress, Inc. (``optionsXpress'') 
dated November 25, 2009 (``optionsXpress Letter'') at 3; Letter from 
Thomas F. Price, Managing Director, Securities Industry and 
Financial Markets Association (``SIFMA'') dated December 1, 2009 
(``SIFMA Letter'') at 5; Letter from Christopher Nagy, Managing 
Director Order Strategy, TD Ameritrade, Inc. (``TD Ameritrade''), 
dated November 23, 2009 (``TD Ameritrade Letter'') at 2.
    \9\ Citadel Letter at 5.
    \10\ Citadel Letter at 6; TD Ameritrade Letter at 4.
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    To assess further these commenter concerns and other issues, the 
Commission is reopening the comment period for the proposed elimination 
of the flash order exception with respect to listed options. Additional 
comment is requested below on, among other things the effect of a 
proposed cap on access fees for listed options,\11\ and on the 
execution quality that flash orders receive in the options markets. The 
Commission is particularly interested in the extent to which flash 
orders, if they fail to receive an execution in the flash process, 
``miss the market'' by either receiving an inferior price through an 
execution against a displayed quotation or no execution at all. No 
useful data was provided on this crucial execution quality issue during 
the initial comment period. Two exchanges that use flash order 
mechanisms indicated that their fill rates for flash orders were in the 
range of 60-70%.\12\ They did not, however, provide data on the 
execution quality, including implementation shortfall, of orders that 
failed to receive an execution in the flash process.
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    \11\ See Securities Exchange Act Release No. 61902 (April 14, 
2010), 75 FR 20738 (April 20, 2010) (``Access Fee Release'') 
(proposing a new rule relating to access to quotations for listed 
options that would cap access fees). Commenters on this release and 
on the Access Fee Release should be aware that the flash order and 
access fee issues, though related, are not necessarily linked. In 
formulating their views, commenters should recognize that the 
Commission will assess each proposal individually and could decide 
to take further action on one or both.
    \12\ Letter from Tony McCormick, Chief Executive Officer, Boston 
Options Exchange Group, LLC (``BOX''), dated November 23, 2009 
(``BOX Letter'') at 1; Letter from Michael J. Simon, General 
Counsel, Secretary and Chief Regulatory Officer, International 
Securities Exchange, LLC (``ISE''), dated November 23, 2009 (``ISE 
Letter'') at 4.
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II. Requests for Comment

    1. Commenters argued that flash orders were necessary in the 
options markets to avoid the access fees that otherwise would be 
charged if the orders were routed to other exchanges. If the Commission 
adopted a cap on access fees for listed options, would the change 
remove the need for exchanges to use flash orders to prevent their 
customers from incurring high access fees? Would the reduction in 
benefits of flash orders for listed options go beyond the direct effect 
of the reduction in access fees, such as through an impact on spreads 
or order book liquidity? If so, how much weight should be given to this 
net reduction in benefits of flash orders in the Commission's analysis 
of the costs and benefits of the Proposal to eliminate the flash order 
exception for listed options?
    2. Comment and data are requested on the execution quality, 
including implementation shortfall of latency or nonexecution, received 
by investor orders in listed options that are placed in a flash 
mechanism.\13\ What percentage of such orders are executed in the flash 
mechanism (that is, by execution against a flash responder)? How do the 
average access fees paid by these flashed orders compare to the average 
access fees the orders would have paid if they had been routed to an 
exchange posting the best quote? For orders that do not receive an 
execution in the flash mechanism, what percentage are routed to other 
exchanges, and what percentage of orders routed to other exchanges 
receive an execution? What proportions of flashed orders that received 
a flash execution, or that were executed at other markets, 
respectively, received an execution at a price better than, equal to, 
or worse than the national best bid or offer (``NBBO'') at the time of 
order receipt at the exchange that flashed the order? Are flash orders 
used more often in certain market conditions, such as at times with 
wider bid-ask spreads? If so, please divide the statistics above by 
those market conditions.
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    \13\ Implementation shortfall measures two components of order 
execution quality for marketable flash orders. First, for orders 
that are executed (whether at the flashing exchange or after routing 
to another exchange), it measures the difference between the trade 
price and the relevant quotation at the time of order receipt at the 
flashing exchange (the national best offer for buy orders and the 
national best bid for sell orders). Second, for orders that are 
cancelled without any execution or with only a partial execution, 
implementation shortfall measures the difference between the 
relevant quotation (as described for executed orders) and an imputed 
price based on the relevant quotation when the order is cancelled.
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    3. Comment and data are requested on the execution quality received 
by investor orders in listed options that are not flashed. To what 
extent do marketable orders receive executions at prices that are 
better than, equal to, or worse than the NBBO at the time of order 
receipt at the exchange that initially receives the order? We 
understand that execution quality statistics comparable to those 
requested above are not widely available to investors and brokers in 
the listed options markets. Are they available to any investors or 
brokers to assess the execution quality of flashed orders? To the 
extent that they are not available, how are investors and brokers able 
to assess execution quality for flashed orders? For example, if 
investors and brokers do not have execution quality statistics for non-
flashed orders in the options markets, how would they be able to 
compare the execution quality of flashed orders with the execution 
quality of orders that are not flashed?
    4. What steps do brokers take to assess whether flashed orders in 
listed options ``miss the market'' by failing to receive either any 
execution or an execution at the NBBO price when the flashing exchange 
initially received the order? What data or other objective evidence do 
brokers use to assess whether flashed orders receive best execution? 
\14\
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    \14\ The Commission notes that the ``Recommendations for Quality 
of Execution Reports for Options Exchanges'' issued by the SIFMA 
Equity Options Trading Committee on July 17, 2008 (``SIFMA 
Recommendations'') do not appear to provide relevant information on 
whether flashed orders miss the market. The SIFMA Recommendations 
specifically exclude orders that an exchange routes away for 
execution elsewhere from the exchange's execution quality 
statistics. The SIFMA Recommendations are available at http://
www.sifma.org/assets/0/232/234/274/bbc1f723-af5b-45ed-b2f2-
1ae7d2f2127d.pdf.
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    5. One commenter suggested that only in ``rare'' instances do 
flashed orders that are routed away ``miss the NBBO market,'' and that 
in those rare instances the brokers typically honor the NBBO for their 
customers.\15\ Do commenters agree with this statement? Does your 
answer depend on whether the NBBO benchmark that is honored is 
understood to be the NBBO at the time of order receipt at the flashing 
exchange, or the NBBO at some other time? Do commenters have any data 
to support their conclusion?
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    \15\ CBOE Letter at 5 n. 5.
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    6. Several commenters stated that liquidity providers at ``maker/
taker'' options exchanges quote more aggressively--that is, by 
displaying quotations that either improve the NBBO or are alone at the 
NBBO--because of the rebates paid to liquidity providers that are 
funded from the access fees charged to liquidity takers.\16\ Do 
commenters agree that liquidity providers on maker/taker exchanges 
quote more aggressively than other exchanges once their displayed 
quotations are adjusted to account for the effect of access fees on the 
``all in'' cost to the investor? If so, are liquidity rebates the only 
reason that liquidity providers on maker/taker exchanges are willing to 
quote aggressively? For example, does the absence of order flow 
captured by payments to routing brokers and the absence of guaranteed 
allocations for liquidity providers also contribute significantly to 
aggressive

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quoting by liquidity providers on maker/taker exchanges?
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    \16\ ISE Letter at 8; Letter from Larry Harris, Professor of 
Finance and Business Economics, USC Marshall School of Business, 
dated December 4, 2009 (``Harris Letter'') at 2.
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    7. The Commission notes the distinction between ``aggressive'' 
quotations and ``matching'' quotations. Aggressive quotations are price 
leaders and help narrow the NBBO spread (by either improving the NBBO 
or remaining alone at the NBBO). Matching quotations follow prices set 
elsewhere and add size to the NBBO, but do not narrow the spread. To 
what extent do liquidity providers on payment for order flow options 
exchanges quote aggressively rather than merely matching the NBBO set 
elsewhere? Would eliminating the flash order exception lead one or both 
types of options exchange to quote more aggressively and thereby narrow 
NBBO spreads for listed options? Does your answer change depending on 
whether the Commission adopts a cap on access fees in the options 
markets that is substantially less than the access fees currently 
charged?
    8. Does the availability of the flash mechanism at payment for 
order flow options exchanges play a significant role in enabling such 
exchanges to compete for order flow through broker payments, rather 
than through offering better prices for the execution of investor 
orders? Would eliminating the flash order exception lead payment for 
order flow options exchanges to respond competitively by more 
aggressive quoting or through greater use of price improvement 
mechanisms targeted at non-professional customer order flow?\17\
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    \17\ In general, a price improvement mechanism exposes incoming 
marketable orders to a competitive auction that provides an 
opportunity for the orders to be executed at better prices than the 
NBBO.
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    9. One commenter noted that there is no over-the-counter (``OTC'') 
trading in listed options and that, as a result, more ``good'' order 
flow (that is, order flow relatively uninformed about future prices) 
reaches the options exchanges than the cash equity exchanges.\18\ 
Another noted that, because quotations must be available for execution 
to all incoming order flow--both informed and uninformed--the 
quotations must be wider than the prices that could be offered 
exclusively to uninformed order flow.\19\ (Prices that could be offered 
exclusively to uninformed order flow could incorporate tighter spreads 
because the market maker does not need to protect itself from adverse 
selection by informed traders by building in a wider spread.) Do 
commenters agree with these statements? If so, do mechanisms that offer 
price improvement attract a large percentage of customer order flow in 
listed options? Why or why not?
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    \18\ ISE Letter, Appendix B at 2.
    \19\ Harris Letter at 4.
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    In this regard, what percentage of order flow in listed options 
participates in the price improvement mechanisms offered by exchanges? 
Is it less than 1% of order flow at most exchanges? Would the figure be 
higher if the Commission eliminated the flash order exception? Are 
there other reasons why price improvement mechanisms do not attract 
significant order flow? Do exchanges need more flexibility in 
distinguishing between informed and uninformed order flow as a means to 
offer better prices to customers that are not professional traders? 
Must price improvement mechanisms guarantee the NBBO to attract order 
flow?
    10. What is the effect on order execution quality, as well as on 
the nature of competition in the options markets, of the absence of 
publicly available order execution quality data comparable to the data 
that is available for cash equities under Rule 605 of Regulation NMS? 
How do investors and customers assess best execution issues for flash 
orders in the absence of mandatory execution quality statistics?

III. Conclusion

    The Commission requests comment and data on the issues discussed 
above, as well as reiterating its discussion and all requests for 
comment in the Proposing Release with respect to listed options. It is 
reopening the comment period on the Proposal to obtain the advantage of 
the public's views on all these issues.

    Dated: July 2, 2010.

    By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-16698 Filed 7-8-10; 8:45 am]
BILLING CODE 8010-01-P

