
[Federal Register Volume 76, Number 57 (Thursday, March 24, 2011)]
[Notices]
[Pages 16650-16652]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-6909]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-64097; File No. SR-BX-2010-079]
Self-Regulatory Organizations; NASDAQ OMX BX, Inc.; Order Approving 
Proposed Rule Change To Amend Chapter IV of the BOX Rules To Allow 
Executing Participants To Provide BOX a List of the Order Flow 
Providers for Which the Executing Participants Will Provide Directed 
Order Services


March 18, 2011.

I. Introduction

    On December 3, 2010, NASDAQ OMX BX, Inc. (the ``Exchange'') filed 
with the Securities and Exchange Commission (``Commission''), pursuant 
to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') 
\1\ and Rule 19b-4 thereunder,\2\ a proposal to amend the rules 
governing its Directed Order process to: (i) Allow an Executing 
Participant (``EP'') to provide BOX a list of the Order Flow Providers 
(``OFPs'') for which the EP will provide Directed Order services and 
(ii) provide that BOX would reveal to the EP the participant ID of the 
OFP sending the Directed Order.\3\ The proposed rule change was 
published for comment in the Federal Register on December 20, 2010.\4\ 
The Commission received no comments on the proposal. This order 
approves the proposal.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Shortly after the filing of the proposed rule change, the 
Exchange withdrew an earlier proposal relating to the non-anonymity 
of Directed Orders (SR-BSE-2005-52). See Securities Exchange Act 
Release No. 53357 (February 23, 2006), 71 FR 10730 (March 2, 2006) 
(SR-BSE-2005-52).
    \4\ See Securities Exchange Act Release No. 63539 (December 14, 
2010), 75 FR 79429 (``Notice'').
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II. Description of the Proposal

    Under the BOX'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 
receiving a Directed Order: (1) Submit the order to the Price 
Improvement Period auction process (``PIP''); \5\ or (2) send the order 
back to BOX for placement onto the BOX Book.
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    \5\ See Chapter V, Section 18 of the BOX Rules.
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    A Market Maker who desires to accept Directed Orders must 
systemically indicate that it is an EP whenever the Market Maker wishes 
to receive Directed Orders from the BOX Trading Host. 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. If a Market Maker has systemically indicated that it wishes to 
receive Directed Orders, it shall not, under any circumstances, reject 
the receipt of a Directed Order from the BOX Trading Host nor reject 
the Directed Order back to the OFP who sent it.\6\
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    \6\ See Chapter VI, Section 5(c)(i) of the BOX Rules.
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    The Exchange proposes to amend Chapter VI, Section 5(c)(i) of the 
BOX Rules to allow EPs to provide BOX a list of OFPs for which the EP 
will provide Directed Order services. Under the proposal, prior to 
accepting any Directed Order through the Trading Host, an EP must 
inform BOX of the OFPs from whom it has agreed to accept Directed 
Orders (``Listed OFPs'' or ``LOFPs''). The Trading Host will then only 
send to the EP Directed Orders from LOFPs. Further, under the proposal, 
the BOX Trading Host would

[[Page 16651]]

reveal to the EP the participant ID of the OFP sending the Directed 
Order.\7\
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    \7\ Pursuant to an existing pilot program, Directed Orders are 
not anonymous. See e.g., Securities Exchange Act Release Nos. 63540 
(December 14, 2010), 75 FR 79432 (December 20, 2010) (continuing the 
practice of non-anonymous Directed Orders, originally established in 
SR-BSE-2006-14, as a pilot program until December 31, 2010 
(``Directed Order Pilot Program'')) and 63591 (December 21, 2010), 
75 FR 81687 (December 28, 2010) (extending the date of the Directed 
Order Pilot Program until June 30, 2011). The proposed rule change 
would make permanent this feature of the Directed Order process.
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III. Discussion

    After careful review of the proposal, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange \8\ and, in particular, the requirements of Section 
6 of the Act.\9\ Specifically, as discussed below, the Commission finds 
that the proposed rule change is consistent with Section 6(b)(5) of the 
Act,\10\ which requires, among other things, that the rules of a 
national securities exchange be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, and processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest; and are not designed to 
permit unfair discrimination among customers, issuers, brokers, or 
dealers.
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    \8\ In approving the proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \9\ 15 U.S.C. 78f.
    \10\ 15 U.S.C. 78f(b)(5).
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    Section 6(b)(5) of the Act prohibits an exchange from establishing 
rules that treat market participants in an unfairly discriminatory 
manner. Section 6(b)(5) of the Act does not prohibit exchange members 
or other broker-dealers from discriminating, so long as their 
activities are otherwise consistent with the Federal securities laws. 
Nor does Section 6(b)(5) of the Act require exchanges to preclude 
discrimination by broker-dealers. Broker-dealers commonly differentiate 
between customers based on the nature and profitability of their 
business.
    Currently under BOX's rules, an Options Participant that is not a 
Market Maker may provide an opportunity for price improvement to a 
customer order by submitting it to the PIP. An Options Participant may 
decide who to accept as its customers and further choose to provide 
price improvement to some customer orders, but not others, by 
exercising discretion as to whether it chooses to send a particular 
order to the PIP auction.\11\ An Options Participant would know the 
identity of its customer in deciding whether to provide this 
opportunity for price improvement. Market Makers may also provide an 
opportunity for price improvement to Directed Orders by submitting them 
into the PIP. The proposed rule change, by permitting a Market Maker to 
designate those OFPs from which it will accept Directed Orders and to 
be provided with the identity of the OFP sending a Directed Order, 
would allow a Market Maker to decide in advance that it will provide an 
opportunity for price improvement only to orders from certain OFPs.\12\ 
Thus, the proposal will provide information to Market Makers that are 
EPs that is the same information available to other BOX members when 
they decide whether to provide price improvement to a particular order.
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    \11\ See also Rule 723 of the International Securities Exchange, 
LLC (Price Improvement Mechanism) and Rule 6.74A of the Chicago 
Board Options Exchange, Incorporated (Automated Improvement 
Mechanism).
    \12\ Specialists and other market makers may establish payment 
for order flow relationships with firms on a discretionary basis. A 
specialist or market maker may pay varying amounts for order flow 
received from different firms or different customers within firms. 
Unlike payment for order flow, which principally benefits 
intermediaries and, indirectly, their customers through possibly 
lower fees and better services, customers' orders executed through 
the PIP auction directly benefit customers with the opportunity for 
an improved price.
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    While customer anonymity may be valuable in ensuring that broker-
dealers comply with legal obligations in a variety of circumstances, 
such as market makers' firm quote obligations, customer anonymity is 
not required of exchanges, particularly when disclosure of customer 
identity could provide benefits to certain customers beyond those 
required by the Federal securities laws or exchange rules. In 
particular, market makers may be willing to offer better execution 
prices to certain customers' orders (e.g., retail customers' orders). 
The Commission does not believe that it would be inconsistent with the 
Federal securities laws for the Exchange to provide, under the 
circumstances set forth in this proposal, the means for its Market 
Makers to differentiate between customers in providing price 
improvement or other non-required advantages to certain customers. The 
Exchange's proposal treats all Market Makers the same and establishes 
no requirements for which OFPs a Market Maker designates as LOFPs or 
for which orders a Market Maker chooses to provide an opportunity for 
price improvement. The Commission does not believe that the absence of 
Exchange rules specifying which orders a Market Maker may execute at 
prices better that its public quote is unfairly discriminatory.
    The Commission notes that allowing a Market Maker to know the 
identity of firms sending Directed Orders may provide further incentive 
to that Market Maker to provide price improvement. A Market Maker that 
receives a Directed Order would be required to decide whether to send 
the order to the PIP and guarantee a price equal to or better than the 
NBBO to such order, or to release the order to the BOX book. The Market 
Maker's decision about whether to choose to guarantee a particular 
order at a price equal to or better than the NBBO may be affected by 
this proposal because it provides Market Makers with information to 
differentiate between orders from informed traders (i.e., their 
competitors) and orders from uninformed traders. It is well known in 
academic literature and industry practice that prices tend to move 
against market makers after trades with informed traders, often 
resulting in losses for market makers.\13\ Thus, there is a strong 
economic rationale for market makers not providing informed traders 
price improvement. Uninformed investors end up bearing the cost of 
these market maker losses through wider spreads that market makers need 
to quote to uninformed investors due to informed order flow.\14\
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    \13\ See Stoll, H. R., ``The supply of dealer services in 
securities of markets,'' Journal of Finance 33 (1978), at 1133-51; 
Glosten, L. and P. Milgrom, ``Bid ask and transaction prices in a 
specialist market with heterogeneously informed agents,'' Journal of 
Financial Economics 14 (1985), at 71-100; and Copeland, T., and D. 
Galai, ``Information effects on the bid-ask spread,'' Journal of 
Finance 38 (1983), at 1457-69.
    \14\ Id.
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    Accordingly, while the Exchange's proposal would permit a BOX 
Market Maker to discriminate among customers in providing prices better 
than its quote, the Commission does not believe that this 
discrimination is inconsistent with Section 6(b)(5) of the Act.
    The Commission continues to believe that under the proposal, a 
Market Maker would maintain the incentive to quote aggressively to gain 
priority with respect to orders entered on the BOX book. Further, the 
Commission believes that there is rigorous competition for order flow 
across options exchanges, such that any widening of quotes on one 
market is an opportunity for another option

[[Page 16652]]

market to capture order flow.\15\ In fact, the Options Order Protection 
and Locked/Crossed Market Plan provides protection from one exchange 
ignoring better quoted prices on another market and will continue to 
promote quote competition across options exchanges.\16\
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    \15\ See Robert Battalio, ``Third Market Broker-Dealers: Cost 
Competitors or Cream Skimmers?'' Journal of Finance, 1997; and 
Robert Battalio, Robert Jason Greene, and Robert Jennings, ``How do 
Competing Specialists and Preferencing Dealers Affect Market 
Quality?'' Review of Financial Studies, 1997.
    \16\ See Securities Exchange Act Release No. 60405 (July 30, 
2009), 74 FR 39362 (August 6, 2009).
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    For the foregoing reasons, the Commission finds that the proposed 
rule change is consistent with the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular with Section 6(b)(5) of the Act.\17\
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    \17\ 15 U.S.C. 78f(b)(5).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (File No. SR-BX-2010-079) is 
approved.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Cathy H. Ahn,
Deputy Secretary.
[FR Doc. 2011-6909 Filed 3-23-11; 8:45 am]
BILLING CODE 8011-01-P


