
[Federal Register Volume 76, Number 60 (Tuesday, March 29, 2011)]
[Notices]
[Pages 17466-17468]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-7285]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-64115; File No. SR-ISE-2006-01]


Self-Regulatory Organizations; International Securities Exchange, 
Inc. (n/k/a the International Securities Exchange, LLC); Order 
Approving a Proposed Rule Change To Amend Exchange Rule Governing 
Directed Orders

March 23, 2011.

I. Introduction

    On January 5, 2006, the International Securities Exchange, Inc. (n/
k/a the International Securities Exchange, LLC) (``ISE'' or 
``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 ISE Rule 811 to allow the identity of a firm entering 
a Directed Order to be disclosed to a Directed Market Maker (``DMM''). 
The proposed rule change was published for comment in the Federal 
Register on January 19, 2006.\3\ The Commission received comment 
letters from the Interactive Brokers Group supporting the proposal, and 
from Citadel opposing the proposal.\4\ This order approves the proposed 
rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 53103 (January 11, 
2006), 71 FR 3144.
    \4\ See letters to Nancy M. Morris, Secretary, Commission, from 
Thomas Peterffy, Chairman, and David M. Battan, Vice President, 
Interactive Brokers Group, dated February 10, 2006 (``IB Letter'') 
and Adam C. Cooper, Senior Managing Director & General Counsel, 
Citadel, dated February 27, 2006 (``Citadel Letter''), incorporating 
by reference a letter from Adam C. Cooper, Senior Managing Director 
& General Counsel, Citadel, dated January 11, 2006 (``Citadel Letter 
II'').
    In reviewing this proposed rule change, the Commission also 
considered a comment letter by the American Stock Exchange in 
response to a proposed rule change submitted by the ISE to amend ISE 
Rule 811 to allow the identity of a firm entering a Directed Order 
to be disclosed to a DMM on a temporary basis, which became 
immediately effective upon filing with the Commission. See 
Securities Exchange Act Release No. 53104 (January 11, 2006), 71 FR 
3142 January 19, 2006 (SR-ISE-2006-02). See also letter to Nancy M. 
Morris, Secretary, Commission, from Neal L. Wolkoff, Chairman & 
Chief Executive Officer, American Stock Exchange, dated February 3, 
2006 (``Amex Letter'') and February 7, 2006 (``Amex Letter II'').
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II. Description of the Proposal

    The Exchange currently operates a Directed Order system in which 
Electronic Access Members (``EAMs'') can send an order to a DMM for 
possible price improvement.\5\ If a DMM accepts Directed Orders 
generally, that DMM must accept all Directed Orders from all EAMs. Once 
such a DMM receives a Directed Order, it either (i) must enter the 
order into the Exchange's Price Improvement Mechanism (``PIM'') auction 
and guarantee its execution at a price better than the ISE best bid or 
offer (``ISE BBO'') by at least a penny and equal to or better than the 
National Best Bid and Offer (``NBBO'') \6\ or (ii) must release the 
order into the Exchange's limit order book, in which case there are 
certain restrictions on the DMM interacting with the order.
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    \5\ See Securities Exchange Act Release No. 52331 (August 24, 
2005), 70 FR 51856 (August 31, 2005) (SR-ISE-2004-16).
    \6\ See ISE Rule 723.
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    On January 5, 2006, ISE filed a proposed rule change, which became 
immediately effective upon filing with the Commission, to alter its 
existing Directed Order system on a temporary basis so that the system 
would disclose the identity of the firm entering a Directed Order to a 
DMM.\7\ The rule permitting the ISE system to identify to DMMs the firm 
from which a Directed Order originates continues to operate on a pilot 
basis through May 31, 2011.\8\ ISE proposes in this filing to amend ISE 
Rule 811 to permit the identity of an EAM that enters a Directed Order 
to be made available to the DMM and thus to make permanent its rule 
change that has been operating on a pilot basis for the past five 
years.
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    \7\ See Securities Exchange Act Release No. 53104 (January 11, 
2006), 71 FR 3142 (January 19, 2006) (rule change was effective 
until June 30, 2006). The Commission received three comment letters 
regarding the temporary system change. See IB Letter, Amex Letter, 
and Amex Letter II, supra note 4.
    \8\ See Securities Exchange Act Release Nos. 53104 (January 11, 
2006), 71 FR 3142 January 19, 2006 (SR-ISE-2006-02); 54083 (June 30, 
2006), 71 FR 38920 (July 10, 2006) (SR-ISE-2006-35); 54542 
(September 29, 2006), 71 FR 59170 (October 6, 2006) (SR-ISE-2006-
57); 55144 (January 22, 2007), 72 FR 3890 (January 26, 2007) (SR-
ISE-2007-05); 56155 (July 27, 2007), 72 FR 43306 (August 3, 2007) 
(SR-ISE-2007-67); 59176 (January 24, 2008), 73 FR 5615 (January 30, 
2008) (SR-ISE-2008-08); 59276 (January 22, 2009), 74 FR 5007 
(January 28, 2009) (SR-ISE-2009-02); 59943 (May 20, 2009), 74 FR 
25296 (May 27, 2009) (SR-ISE-2009-28); 60956 (November 6, 2009), 74 
FR 58674 (November 13, 2009) (SR-ISE-2009-93); and 63357 (November 
22, 2010), 75 FR 73144 (November 29, 2010) (SR-ISE-2010-110).
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III. Discussion

    After careful review of the proposal and of the comment letters, 
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 \9\ and, in

[[Page 17467]]

particular, the requirements of Section 6 of the Act.\10\ Specifically, 
as discussed below, the Commission finds that the proposed rule change 
is consistent with Section 6(b)(5) of the Act,\11\ 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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    \9\ Citadel argues that this proposal facilitates anti-
competitive behavior and therefore violates Section 3(f) of the Act. 
See Citadel Letter II, supra note 4, at 6. Section 3(f) of the Act 
requires the Commission to consider or determine whether this 
proposed rule change is necessary or appropriate in the public 
interest and, in addition to the protection of investors, will 
promote efficiency, competition, and capital formation. In approving 
this proposed rule change, the Commission has considered the 
proposed rule's impact on efficiency, competition, and capital 
formation. As discussed below, the Commission does not believe the 
proposal is anti-competitive. 15 U.S.C. 78c(f).
    \10\ 15 U.S.C. 78f.
    \11\ 15 U.S.C. 78f(b)(5).
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A. Proposal is Not Unfairly Discriminatory

    Under the proposal, the ISE system would provide the identity of an 
EAM that enters a Directed Order to the DMM to whom the order is 
directed. Citadel argues that the lack of anonymity of Directed Orders 
allows the DMM receiving such orders to discriminate in its 
determination regarding for which orders the DMM would provide an 
opportunity for price improvement through the ISE's PIM auction.\12\ 
The principal criticism of ISE's proposal is that it is inconsistent 
with the requirement in Section 6(b)(5) of the Act that the rules of an 
exchange not be ``designed to permit unfair discrimination between 
customers, issuers, brokers, or dealers.'' \13\ Section 6(b)(5) of the 
Act prohibits an exchange from establishing rules that treat these 
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.
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    \12\ See Citadel Letter II, supra note 4, at 4-5.
    \13\ 15 U.S.C. 78f(b)(5). See Citadel Letter II, supra note 4, 
at 5; and Amex Letter, supra note 4, at 2.
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    Currently under ISE's rules, an EAM may provide an opportunity for 
price improvement to a customer order by submitting it to the PIM. An 
EAM may decide who to accept as its customers and further choose to 
provide an opportunity for price improvement to some customer orders, 
but not others, by exercising discretion as to whether it chooses to 
send a particular order to the PIM auction.\14\ An EAM would know the 
identity of its customer in deciding whether to provide this 
opportunity for price improvement. A DMM may also provide an 
opportunity for price improvement to Directed Orders by submitting them 
to the PIM. The proposed rule change would enable a DMM to consider the 
identity of the EAM directing the order when deciding whether to 
provide an opportunity for price improvement.\15\ Thus, the proposal 
will provide information to DMMs that is the same information available 
to other ISE members when they decide whether to provide price 
improvement to a particular order.
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    \14\ See also Chapter V, Section 18 of the Boston Options 
Exchange Rules (Price Improvement Period) and Rule 6.74A of the 
Chicago Board Options Exchange, Incorporated (Automated Improvement 
Mechanism).
    \15\ 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 PIM 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 DMMs to 
differentiate between customers in providing price improvement or other 
non-required advantages to certain customers. The Exchange's proposal 
treats all DMMs the same and establishes no requirements for which 
orders a DMM chooses to provide an opportunity for price improvement. 
The Commission does not believe that the absence of Exchange rules 
specifying which orders a DMM may execute at prices better that its 
public quote is unfairly discriminatory.
    Accordingly, while the proposal would permit a DMM 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.

B. Impact of Proposal on Market Quality and Competition

    Citadel argues that the proposal would discourage aggressive 
quoting and would be detrimental to price improvement.\16\ The 
Commission has considered this comment and does not believe that the 
rule change proposed by ISE would discourage DMMs from quoting 
aggressively. The Commission believes that a DMM has an incentive to 
quote aggressively to gain priority with respect to orders entered on 
the limit order book. Further, the Commission believes that the 
commenter's argument that the proposal will harm market quality rests 
on a number of premises that are unlikely to occur. The commenter 
assumes that ISE's proposal will lead to less aggressive quoting across 
all options exchanges and a widening of the NBBO. The Commission does 
not believe that this will occur because there is rigorous competition 
for order flow across options exchanges so any widening of quotes on 
one market is an opportunity for another option market to capture order 
flow.\17\ 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.\18\
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    \16\ See Citadel Letter II, supra note 4, at 8-9.
    \17\ 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.
    \18\ See Securities Exchange Act Release No. 60405 (July 30, 
2009), 74 FR 39362 (August 6, 2009).
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    In addition, allowing a DMM to know the identity of firms sending 
Directed Orders may provide further incentive to that DMM to provide 
price improvement. A DMM that receives a Directed Order would be 
required to decide whether to send the order to the

[[Page 17468]]

PIM and guarantee a price better than the ISE BBO and equal to or 
better than the NBBO to such order, or to release the order to the 
book. The DMM's decision about whether to choose to guarantee a 
particular order at a price better than the ISE BBO and equal to or 
better than the NBBO may be affected by this proposal because it 
provides DMMs 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.\19\ 
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.\20\
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    \19\ 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.
    \20\ Id.
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    Citadel also argues that the Commission has previously sought to 
eliminate similar anti-competitive practices allowed by self-regulatory 
organizations (``SROs'') involving lack of order anonymity.\21\ In 
particular, Citadel cites a 1996 investigation of NASD and Nasdaq Stock 
Market in which ``[s]ome market makers, without disclosure to their 
customers, shared information with each other about their customers' 
orders, including the size of the order and, on occasion, the identity 
of the customer.'' \22\ Citadel asserts that the ``Commission concluded 
that this anti-competitive behavior violated the antifraud provisions 
of the Exchange Act, among other provisions.'' \23\
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    \21\ See Citadel Letter II, supra note 4, at 6.
    \22\ See Securities Exchange Act Release No. 37542 (August 8, 
1996) (File No. 3-8919) (Report Pursuant to Section 21(a) of the 
Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq 
Market), at 5.
    \23\ See Citadel Letter II, supra note 4, at 6.
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    The Commission does not believe that the proposal will result in 
market maker conduct like that in the NASD case, which found that 
market makers were collaborating with other market participants against 
the interests of their customers contrary to the fair dealing 
obligations of market makers.\24\ Unlike the NASD case, the interests 
of the DMM's customers are not harmed by this proposal because 
information pertaining to a DMM's Directed Orders is not shared among 
competing DMMs and all orders sent to ISE must be executed at a price 
no worse than the NBBO.\25\
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    \24\ See Securities Exchange Act Release No. 37542, supra note 
22, at 59.
    \25\ See ISE Rule 811(e).
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    Finally, Amex contends that the proposal is anti-competitive 
because providing the identity of an EAM to DMMs provides them with the 
ability to enter into anti-competitive customer allocation 
arrangements.\26\ Amex argues that if ISE Market Makers know the 
identities of order flow providers, they could agree to allocate those 
order flow providers among themselves and provide price improvement to 
only those that each has been allocated.\27\ There is, however, no 
evidence that customer allocation arrangements exist between Market 
Makers. The Commission is today approving only the proposed rule 
change, which permits a DMM to determine from which EAM it will accept 
Directed Orders. The Commission is not approving any customer 
allocation arrangements among Market Makers.
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    \26\ See Amex Letter, supra note 4, at 2.
    \27\ Id.
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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.\28\
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    \28\ 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,\29\ that the proposed rule change (SR-ISE-2006-01) is approved.
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    \29\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\30\
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    \30\ 17 CFR 200.30-3(a)(12).
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Cathy H. Ahn,
Deputy Secretary.
[FR Doc. 2011-7285 Filed 3-28-11; 8:45 am]
BILLING CODE 8011-01-P


