
[Federal Register Volume 78, Number 211 (Thursday, October 31, 2013)]
[Notices]
[Pages 65396-65400]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-25829]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-70756; File No. SR-BX-2013-016]


Self-Regulatory Organizations; NASDAQ OMX BX Inc.; Order 
Disapproving Proposed Rule Change To Adopt a Directed Order Process

October 25, 2013.

I. Introduction

    On February 21, 2013, NASDAQ OMX BX Inc. (``Exchange'' or ``BX'') 
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 proposed rule change to 
establish a directed order process for the trading of listed options. 
The proposed rule change was published for comment in the Federal 
Register on March 11, 2013.\3\ The Commission received a comment letter 
on the proposal,\4\ BX's response to the comment letter,\5\ and a 
follow up comment letter from the same commenter.\6\ On April 17, 2013, 
BX filed Amendment No. 1 to the proposed rule change.\7\ On April 22, 
2013, BX extended to June 6, 2013 the time period within which the 
Commission must approve the proposed rule change, disapprove the 
proposed rule change, or institute proceedings to determine whether to 
disapprove the proposed rule change. On June 3, 2013, the Commission 
instituted proceedings to determine whether to approve or disapprove 
the proposed rule change.\8\ The Commission received a letter from BX 
responding to the Order Instituting Proceedings,\9\ another comment 
letter from the same commenter--NYSE Euronext--who had commented 
previously on the proposed rule change,\10\ and a follow up letter from 
BX in response to NYSE Euronext's comment letter.\11\ This order 
disapproves the proposed rule change.
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    \1\ 15 U.S.C. 78a.
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 69040 (March 5, 
2013), 78 FR 15385 (``Notice'').
    \4\ See Letter, dated April 2, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Janet McGuiness, Executive Vice 
President, Secretary and General Counsel, NYSE Euronext (``NYSE 
Euronext Letter 1''). For a summary of this letter, see Securities 
Exchange Act Release No. 69684 (June 3, 2013), 78 FR 34683 (June 10, 
2013) (``Order Instituting Proceedings'').
    \5\ See Letter, dated April 17, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Edith Hallahan, Principal Associate 
General Counsel, BX (``BX Letter 1''). For a summary of this letter, 
see Order Instituting Proceedings, supra note 4, 78 FR at 34685.
    \6\ See Letter, dated May 10, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Janet McGuiness, Executive Vice 
President, Secretary and General Counsel, NYSE Euronext (``NYSE 
Euronext Letter 2''). For a summary of this letter, see Order 
Instituting Proceedings, supra note 4, 78 FR at 34685.
    \7\ Amendment No. 1, which the Commission believes is technical 
in nature and not subject to notice and comment, clarifies that, 
when a Directed Order (as defined below) is submitted in an options 
class that is subject to the price/time priority on BX, the Directed 
Market Maker's Directed Allocation (as defined below) would be 
capped at 40%, unless the Directed Market Maker's size at the first 
position in time priority at that price exceeds 40%, in which case 
the Directed Market Maker would have priority for that size.
    \8\ See Order Instituting Proceedings, supra note 4.
    \9\ See Letter, dated July 1, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Edith Hallahan, Principal Associate 
General Counsel, BX (``BX Letter 2'').
    \10\ See Letter, dated July 15, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Janet McGuiness, Executive Vice 
President, Secretary and General Counsel, NYSE Euronext (``NYSE 
Euronext Letter 3'').
    \11\ See Letter, dated August 28, 2013, to Elizabeth M. Murphy, 
Secretary, Commission, from Edith Hallahan, Principal Associate 
General Counsel, BX (``BX Letter 3'').
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II. Description of the Proposal

    BX proposes to establish a directed order process that would permit 
members of BX (``BX Participants'') to direct orders in listed options 
(``Directed Orders'') to a particular market maker on BX (``Directed 
Market Maker'').\12\ As detailed below, a Directed Market Maker would 
be eligible to receive an allocated percentage of the Directed Order 
(40%) at all price levels at which the Directed Market Maker has a 
quote or order (a ``Directed Allocation'').\13\ To receive a Directed 
Allocation, the Directed Market Maker would be required to have quotes 
or orders at the National Best Bid or National Best Offer (``NBBO'') at 
the time of the execution of the Directed Order; the Directed Market 
Maker would not be required to be quoting at the NBBO at the time the 
Directed Order is received.\14\ If a Directed Order is not executed 
upon receipt, it would be

[[Page 65397]]

placed on the BX book and would retain its status as a Directed 
Order.\15\
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    \12\ Specifically, BX proposes to add BX Chapter VI, Section 
1(e)(1) to Chapter VI to define a Directed Order as ``an order to 
buy or sell which has been directed (pursuant to BX's instructions 
on how to direct an order) to a particular Market Maker (``Directed 
Market Maker'') after the opening.'' BX also proposes to amend BX 
Chapter VI, Section 6(a)(2) to include Directed Order to the list of 
orders handled within the BX System.
    \13\ Proposed BX Chapter VI, Section 10(3)(iv)(C).
    \14\ For example, as shown in Example 4 in the Notice, if BX was 
not at the National Best Offer (``NBO'') and the Directed Market 
Maker was quoting one tick away from the NBO at the time a Directed 
Order was received, once the NBO was exhausted and BX became the new 
NBO, the Directed Order could be executed at this new NBO and the 
Directed Market Maker would receive its Directed Allocation, even 
though the Directed Market Maker was not at the NBO at when the 
order was received.
    \15\ Proposed BX Chapter VI, Section 10(3)(iv)(C). For example, 
if a marketable non-routable Directed Order to buy is received on BX 
and BX is not quoting at the NBO, the order could not be executed on 
BX and could not route. See BX Chapter VI, Section 7(b)(3)(C) 
(providing that ``[a]n order will not be executed at a price that 
trades through another market. . . .''). Thus, under BX's rules, the 
order would be posted on the BX book at the current NBB but 
displayed one minimum price increment below the NBO. See BX Chapter 
VI, Section 7(b)(3)(C). If the market moves such that the BX best 
offer is now the NBO, the Directed Order would be executed against 
the BX best offer, which is now the NBO, and the Directed Market 
Maker would receive a Directed Allocation of 40% of the Directed 
Order. See Notice, supra note 3, at 15390.
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    The calculation of a Directed Market Maker's Directed Allocation 
would depend on whether the Directed Order is submitted in an options 
class that is subject to price/time priority or in an options class 
that is subject to the size pro-rata execution algorithm on BX. 
Specifically, if an option is subject to price/time priority, a 
Directed Market Maker who has time priority at a particular price would 
receive the amount of the Directed Order equal to the Directed Market 
Maker's quotes/orders with time priority at that price. However, if the 
Directed Market Maker does not have time priority for a size equal to 
or greater than 40% of the Directed Allocation, the Directed Market 
Maker would receive a Directed Allocation of 40% of the Directed Order 
at a particular price.\16\
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    \16\ Proposed BX Chapter VI, Section 10(3)(i)(A). See also 
Amendment No. 1, supra note 7.
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    If a Directed Order is submitted in an options class that is 
subject to the size pro-rata execution algorithm, any public customer 
limit orders resting on the limit order book at the execution price 
would first be executed against the Directed Order.\17\ Once all public 
customer limit orders are executed, the Directed Market Maker would 
receive the greater of: (1) The pro-rata allocation to which such 
Directed Market Maker would be entitled or (2) 40% of the original size 
of the Directed Order at that particular price. Once the Directed 
Allocation is determined, BX proposes to allocate all remaining 
contracts of the Directed Order on a size pro-rata basis among all 
remaining participants (except for the Directed Market Maker).
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    \17\ Proposed BX Chapter VI, Section 10(3)(i)(B).
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    If the calculation of the 40% Directed Allocation results in a 
fractional remainder, BX proposes to round up the Directed Market 
Maker's Directed Allocation to the next whole number whether the 
Directed Order is submitted in an options class subject to price/time 
priority or in an options class that is subject to the size pro-rata 
execution algorithm.\18\ In addition, the Directed Market Maker would 
not be entitled to receive a number of contracts that is greater than 
the size associated with its quote or order at a particular price.\19\
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    \18\ Proposed BX Chapter VI, Section 10(3)(iv)(B).
    \19\ Proposed BX Chapter VI, Section 10(3)(iv)(A).
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    BX also proposes to reduce the quoting obligations applicable to 
its Market Makers that are not Directed Market Makers. Currently, BX 
Market Makers are required to quote during regular market hours on a 
continuous basis (i.e., 90% of the trading day) in at least 60% of the 
series in options in which the Market Maker is registered. The proposed 
rule would reduce this requirement such that Market Makers would be 
required to quote 60% of the trading day (as a percentage of the total 
number of minutes in such trading day) or such higher percentage as BX 
may announce in advance, in all options in which the Market Maker is 
registered.
    The quoting obligations applicable to Directed Market Makers would 
be higher than those applicable to Market Makers that are not Directed 
Market Makers. Specifically, Directed Market Makers would be required 
to quote such options 90% of the trading day (as a percentage of the 
total number of minutes in such trading day) or such higher percentage 
as BX announces in advance, applied collectively to all series in all 
of the option classes in which the Directed Market Maker receives 
Directed Orders (rather than on an option-by-option basis). Once a 
Directed Market Maker receives a Directed Order, the heightened quoting 
obligation is triggered and applies to the options in which the 
Directed Market Maker receives the Directed Order. The Directed Market 
Maker would be required to comply with the heightened quoting 
requirements only upon receiving a Directed Order in a class, and the 
heightened quoting requirements would be applicable until the end of 
the calendar month.

III. Discussion

    Under Section 19(b)(2)(C) of the Act, the Commission shall approve 
a proposed rule change of a self-regulatory organization if the 
Commission finds that such proposed rule change is consistent with the 
requirements of the Act, and the rules and regulations thereunder that 
are applicable to such organization.\20\ The Commission shall 
disapprove a proposed rule change if it does make such a finding.\21\ 
The Commission's Rules of Practice, under Rule 700(b)(3), state that 
the ``burden to demonstrate that a proposed rule change is consistent 
with the [Act] . . . is on the self-regulatory organization that 
proposed the rule change'' and that a ``mere assertion that the 
proposed rule change is consistent with those requirements . . . is not 
sufficient.'' \22\
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    \20\ 15 U.S.C. 78s(b)(2)(C)(i).
    \21\ 15 U.S.C. 78s(b)(2)(C)(i); see also 17 CFR 201.700(b)(3) 
and note 25 infra, and accompanying text.
    \22\ 17 CFR 201.700(b)(3). The description of a proposed rule 
change, its purpose and operation, its effect, and a legal analysis 
of its consistency with applicable requirements must all be 
sufficiently detailed and specific to support an affirmative 
Commission finding. See id. Any failure of a self-regulatory 
organization to provide the information solicited by Form 19b-4 may 
result in the Commission not having a sufficient basis to make an 
affirmative finding that a proposed rule change is consistent with 
the Act and the rules and regulations issued thereunder that are 
applicable to the self-regulatory organization. Id.
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    After careful consideration, the Commission does not find 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.\23\ In particular, the Commission does not find 
that the proposed rule change is consistent with Section 6(b)(5) of the 
Act,\24\ which requires that the rules of a national securities 
exchange be designed, among other things, to prevent fraudulent and 
manipulative acts and practices, 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 to protect 
investors and the public interest.
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    \23\ In disapproving 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).
    \24\ 15 U.S.C. 78f(b)(5).
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    In the Order Instituting Proceedings, the Commission summarized the 
comments received and BX's response, and noted several concerns that 
raise questions as to whether the BX proposal is consistent with the 
requirements of Section 6(b)(5) of the Act, including whether the 
proposed process for handling Directed Orders would promote just and 
equitable principles of trade, perfect the mechanism of a free and open 
market and the national market system, or protect investors and the 
public interest.\25\ Specifically, the Commission stated that the 
proposal raises the following issues: (1) Whether BX's proposal would 
protect investors in that the proposal would provide Directed Market 
Makers with priority for Directed Allocations ahead of public customer 
limit orders that arrived first in time; and (2) how the proposed rules

[[Page 65398]]

would impact quote competition on BX, and how any impact on quote 
competition on BX in turn would impact execution quality on BX.\26\ The 
Commission invited interested persons to submit written views with 
respect to these concerns. The Commission received three letters in 
response to the Order Instituting Proceedings, two of which were from 
BX.\27\
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    \25\ See Order Instituting Proceedings, supra note 4, at 34686.
    \26\ Id.
    \27\ See BX Letter 2, supra note 9 and NYSE Euronext Letter 3, 
supra note 10; see also BX Letter 3, supra note 11.
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    The Commission recognizes that it has previously approved rules of 
other national securities exchanges that provide for directed order 
programs.\28\ BX's proposed Directed Order rules, however, deviate from 
the directed order rules of other exchanges previously approved by the 
Commission, as described in more detail below. First, BX proposes to 
provide a Directed Market Maker time priority over pre-existing 
customer orders in certain instances. In addition, unlike other 
exchanges with directed order programs, BX would not require its 
Directed Market Makers to quote at the NBBO at the time a Directed 
Order is received to be eligible to receive an execution guarantee; 
rather, BX would only require its Directed Market Makers to be at the 
NBBO at the time the Directed Order is executed. BX also deviates from 
other exchanges in its proposal to apply heightened quoting 
requirements only after a Directed Market Maker receives a Directed 
Order in a given month.
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    \28\ See Securities Exchange Act Release No. 51759 (May 27, 
2005), 70 FR 32860 at 32861 (June 6, 2005) (SR-Phlx-2004-91) (``Phlx 
Order''); see also e.g., Securities Exchange Act Release Nos. 47628 
(April 3, 2003), 68 FR 17697 (April 10, 2003) (SR-CBOE-00-55) 
(``CBOE Order''); 52331 (August 24, 2005), 70 FR 51856 (August 31, 
2005) (SR-ISE-2004-16) (``ISE Order''); 59472 (February 27, 2009) 74 
FR 9843 (March 6, 2009) (SR-NYSEALTR-2008-14) (``NYSEALTR Order''); 
60469 (August 10, 2009), 74 FR 41478 (August 17, 2009) (SR-NYSEArca-
2009-73) (``NYSE Arca Notice''); and 68070 (October 18, 2012), 77 FR 
65037 (October 18, 2012) (SR-C2-2012-24) (``C2 Order'').
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A. No Public Customer Priority

    As outlined above, BX's proposed Directed Order rule would provide, 
in options classes utilizing the price/time allocation methodology, the 
Directed Market Maker with priority for the 40% allocation ahead of 
public customer orders. Specifically, the Directed Market Maker's 
allocation would go ahead of public customer orders that otherwise had 
time priority over the Directed Market Maker's quote.
    NYSE Euronext commented on this aspect of BX's proposal, noting 
that, under BX's proposal, a Directed Market Maker that submits a quote 
after a public customer who has aggressively improved the NBBO would 
receive a Directed Allocation that the earlier-arriving public customer 
could potentially have completely filled. According to NYSE Euronext, 
public customers would not be fully rewarded for providing an 
aggressive quote and thus the incentives to improve the NBBO would 
decrease, resulting in fewer displayed public customer orders and fewer 
public customers willing to improve the NBBO.\29\
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    \29\ See NYSE Euronext Letter 2, supra note 6, at 3-4.
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    In response to NYSE Euronext's comment letter, BX argues that 
customer priority is not mandated by the Act or the rules and 
regulations thereunder.\30\ BX also argues that it is reasonable and 
consistent with applicable statutory standards for a Directed Market 
Maker's quote to execute against a Directed Order before a priority 
customer order that goes ahead of the Directed Market Maker quote in 
time priority, stating that public customer orders are not precluded 
from participating in the trade, but rather continue to stand in time 
priority once the Directed Order's execution guarantee is 
satisfied.\31\ BX contends that public customers may not have otherwise 
received an execution on BX because the Directed Market Maker may have 
attracted the Directed Order to BX as a result of the Directed Market 
Maker's relationship with the order flow provider.\32\
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    \30\ See BX Letter 2, supra note 9, at 3.
    \31\ See Notice, supra note 3, at 15388. See also BX Letter 2, 
supra note 9, at 3-4.
    \32\ Id.
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    NYSE Euronext also notes the longstanding history of distinguishing 
public customers from professionals and allowing advantages to public 
customer orders.\33\ NYSE Euronext states its belief that BX is 
attempting to ``turn this distinction [between a public customer and a 
professional] on its head'' by providing preferential treatment to 
sophisticated professionals rather than public customers.\34\ NYSE 
Euronext argues further that it would be inconsistent with the 
protection of investors if other exchanges followed the approach of 
treating directed orders in the same manner as BX, resulting in public 
customers losing priority and receiving fewer fills.\35\
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    \33\ See NYSE Euronext Letter 2, supra note 6, at 3-4.
    \34\ See NYSE Euronext Letter 3, supra note 10, at 4. See also 
NYSE Euronext Letter 2, supra note 6, at 2-3.
    \35\ See NYSE Euronext Letter 3, supra note 10, at 5. (citing 
Securities Exchange Act Release No. 42808 (May 22, 2000), 65 FR 
34515, 34517 (May 30, 2000) (SR-ISE-00-01)).
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    In response, BX states its view that the distinction between public 
customers and professionals was rooted in floor-based trading models 
where customers were not charged fees and in pro rata priority models 
where there were opportunities for professionals to ``size out'' public 
customers, therefore there was a particular need for public customer 
priority.\36\ BX argues that currently other trading models are used by 
the options exchanges, and that under a price/time model public 
customers do not need the same protection as under a pro rata model. BX 
also argues that its proposal rewards a specific category of market 
participants who have general market making obligations that are 
critical to the functioning of the market in addition to enhanced 
obligations, which qualify them for a Directed Allocation.\37\ In 
response to NYSE Euronext's argument that it would be inconsistent with 
the protection of investors if other exchanges followed the approach of 
treating directed orders in the same manner as BX, BX notes that NYSE 
Euronext can choose not to adopt a similar approach on its markets, and 
if BX's proposed approach is not successful based on its treatment of 
customer orders, NYSE Euronext might benefit.\38\ BX also reiterates 
its argument that Directed Orders attract liquidity to the Exchange, 
and that a customer order on BX could remain unfilled if a Directed 
Order is not routed to BX, in favor of another option exchange that 
would allow the order to be directed to a particular market maker.\39\
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    \36\ See BX Letter 2, supra note 9, at 3.
    \37\ See BX Letter 3, supra note 11, at 2.
    \38\ Id.
    \39\ Id.; see also BX Letter 2, supra note 9, at 3-4.
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    The directed order rules of other exchanges all provide for public 
customer priority over directed order market makers at a particular 
price level, whether the exchange has a pro-rata allocation methodology 
or a price/time allocation methodology.\40\ The

[[Page 65399]]

rules of the one options exchange that has a directed order program in 
a price/time allocation market do not allow the directed market maker 
participation entitlement to step ahead of customer orders that have 
time priority over the directed market maker's quote or order.\41\ 
Similar to the other exchanges, under BX's proposal, if the option is 
subject to the pro-rata execution algorithm, public customer limit 
orders resting on the limit order book at the execution price will 
execute against the Directed Order first, before the 40% allocation to 
the Directed Market Maker.\42\ To the contrary, however, BX's proposal 
would not protect any public customer orders under a price/time 
allocation methodology. Instead, it would allow the Directed Market 
Maker's quote or order to go ahead of earlier-arriving public customer 
orders based solely on the relationship of the Directed Market Maker 
with the order flow provider that sent the Directed Order.
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    \40\ See, e.g., C2 Rules 6.12 and 8.17; CBOE Rule 8.13; NYSE 
Rule 964NY; and ISE Rule 713 (pro-rata allocation methodology) and 
NYSE Arca Rule 6.76A (time priority allocation methodology. See, 
e.g., Securities Exchange Act Release 42808 (May 22, 2000), 65 FR 
34515, 34517 (May 30, 2000) (SR-ISE-00-01) (``Although the 
Commission recognizes that intramarket competition, as well as 
protection of public customers, could be compromised if such a 
participation right constituted an absolute guarantee or if it 
consumed too great a percentage of order flow, the Commission 
believes that the ISE's proposal sets forth reasonable safeguards 
against such potential harms. The ISE's proposal prioritizes public 
customer limit orders on the book. Indeed, if sufficient existing 
customer interest exists a PMM might not receive any allocation of a 
given incoming order. . . . The Commission believes that these 
limits on a PMM's participation right should assure reasonable 
protection for public customers and prevent impediments to a free 
and open market that might otherwise result from an absolute 
specialist guarantee.'') (order approving rules related to market 
maker participation rights).
    \41\ See NYSE Arca Rule 6.76A, which provides that the 
participation entitlement has priority over other orders except 
customer orders that were ranked ahead of the directed market 
maker's quote or order in time priority. See NYSE Arca Notice, supra 
note 28, at 41479.
    \42\ Proposed BX Chapter VI, Section 10(3)(i)(B).
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    The Commission believes that BX's failure to accord protection to 
public customer orders would result in an execution allocation that is 
inconsistent with Section 6(b)(5) of the Act, which requires that the 
rules of an exchange must designed, among other things, to protect 
investors.\43\ Specifically, rather than giving priority to public 
customer orders or placing public customers and Directed Market Makers 
on an equal footing, BX's proposal would, by allowing Directed Market 
Maker quotes or orders to ``jump'' the price/time queue over previously 
received public customers limit orders, disadvantage public customer 
orders in order to give a trading benefit to Directed Market Makers in 
contravention of Section 6(b)(5) of the Exchange Act.\44\
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    \43\ 15 U.S.C. 78f(b)(5).
    \44\ 15 U.S.C. 78f(b)(5).
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B. NBBO Quoting Requirement

    Unlike other exchanges with directed order programs, BX would not 
require its Directed Market Makers to be quoting at the NBBO at the 
time a Directed Order is received to be eligible to receive an 
execution guarantee.\45\ Rather, BX would only require its Directed 
Market Makers to be quoting at the NBBO at the time the Directed Order 
is executed.\46\ In its filing, BX supports this aspect of its proposal 
by stating its belief that because executions occur across multiple 
prices with simultaneous routing, the availability of the participation 
entitlement should not be limited by the requirement that Directed 
Market Makers be quoting at the NBBO at the time the Directed Order is 
received.\47\
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    \45\ See, e.g., Securities Exchange Act Release 51818 (June 10, 
2005), 70 FR 35146, 35149-50 (June 16, 2005) (SR-ISE-2005-18) (``The 
Commission has previously approved rules that guarantee a Primary 
Market Maker a portion of each order when the Primary Market Maker's 
quote is equal to the NBBO . . . . [A] Preferred Market Maker will 
have to be quoting at the NBBO at the time the Preferenced Order is 
received to capitalize on the participation guarantee. The 
Commission believes it is critical that the Preferred Market Maker 
cannot step up and match the NBBO after it receives an order, but 
must be publicly quoting at that price when the order is 
received.'') (order approving rules relating to preferencing of 
market maker orders).
    \46\ Under BX's proposal, if the Directed Market Maker is not at 
the NBBO at the time a Directed Order is received, the order would 
first execute against available interest at the NBBO. If the orders 
at the NBBO on BX and on away markets are executed so that the 
Directed Market Maker is at the NBBO, and there is remaining size 
available from the Directed Order, the Directed Market Maker would 
receive its execution guarantee (40% of the remaining shares) at 
each price level at which the Directed Market Maker has quotes/
orders.
    \47\ See Notice, supra note 3, at 15389.
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    NYSE Euronext expressed concern with BX's proposed rule to allow a 
Market Maker to receive a Directed Allocation when the Market Maker 
does not have a quote at the NBBO at the time the Directed Order is 
received by BX. NYSE Euronext stated that in approving rule proposals 
that guarantee an allocation to a market maker, the Commission has 
consistently focused on two distinct aspects of the proposals, one of 
which is that the market maker's quote is equal to the NBBO at the time 
of receipt of the order.\48\ NYSE Euronext states that the Commission 
has granted the increased reward of a preferential directed order 
allocation only to market makers who are taking the commensurate risk 
of quoting at the NBBO, and appropriately so: posting firm quotes 
acceptable by all participants at the NBBO is a benefit to all 
participants in that it fosters price discovery and transparency.\49\
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    \48\ See NYSE Euronext Letter 2, supra note 6, at 2.
    \49\ See NYSE Euronext Letter 1, supra note 4, at 5.
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    NYSE Euronext states that BX's proposed rule would be unprecedented 
and would be detrimental to transparency and price discovery by 
destroying incentives for market makers to quote aggressively at the 
NBBO.\50\ Specifically, NYSE Euronext argues that by rewarding market 
makers whose quotes are not the most aggressive, the BX proposal will 
encourage market makers to quote away from the inside market, and that 
the Exchange's proposal would deteriorate market makers' incentives to 
compete for incoming orders based on price.\51\ According to NYSE 
Euronext, a market maker could ``lay in wait'' outside the NBBO, 
allowing other participants to participate in the order at less 
attractive prices, while the market maker receives a 40% participation 
entitlement for that portion of the Directed Order that trades at the 
more attractive price.\52\ NYSE Euronext also believes that Directed 
Market Makers will have no incentive to match or improve the NBBO of a 
thinly traded option due to the low risk that a Directed Order will be 
fully executed against a better-priced order.\53\
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    \50\ Id.
    \51\ See NYSE Euronext Letter 2, supra note 6, at 1.
    \52\ See NYSE Euronext Letter 1, supra note 4, at 5.
    \53\ See NYSE Euronext Letter 2, supra note 6, at 4.
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    NYSE Euronext further argues that, although BX believes its 
proposed rule will increase depth of market, BX fails to acknowledge 
that such an increase would be the result of fewer Directed Market 
Makers quoting at the NBBO.\54\ Rather than create additional 
liquidity, NYSE Euronext believes that BX's proposal would shift 
liquidity from the top-of-book to depth-of-book.\55\
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    \54\ See NYSE Euronext Letter 3, supra note 10, at 2.
    \55\ Id. at 4.
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    In response to these concerns, BX acknowledges that its proposal 
does break new ground, but stresses that to receive an execution of a 
Directed Order, a Directed Market Maker must be quoting at the NBBO at 
the time of execution, and that there would never be an allocation to a 
quote outside the NBBO.\56\ BX maintains that its proposed program will 
help make market makers quote more competitively, not less.\57\ 
Specifically, BX notes that, in order for a Directed Market Maker to 
execute an order at a particular price, all orders at more aggressive 
prices will first have to be executed.\58\ As a result, BX believes 
that Directed Market Makers will be incentivized to provide their best 
quote and add depth to the market.\59\
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    \56\ See BX Letter 1, supra note 5, at 2.
    \57\ See BX Letter 3, supra note 11, at 2.
    \58\ See BX Letter 1, supra note 5, at 3.
    \59\ Id.
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    BX also argues that a market maker who chooses to quote at a price 
other than the inside is providing value and depth at that price when 
orders trade at

[[Page 65400]]

multiple price levels and when that price becomes the NBBO, thus 
benefitting investors.\60\ In particular, BX argues that its proposal 
addresses the reality of multiple prices and creates an ability to 
efficiently execute a larger volume of an order, particularly when the 
NBBO is for a small size. Thus, according to BX, its proposal 
``recognizes the new NBBO and preserves the requirement that the 
Directed Market Maker be at the NBBO'' (emphasis in original).\61\
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    \60\ See BX Letter 1, supra note 5, at 3. See also BX Letter 2, 
supra note 9, at 2.
    \61\ See BX Letter 1, supra note 5, at 2. See also BX Letter 2, 
supra note 9, at 2, 4.
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    BX disagrees with NYSE Euronext's contention that liquidity would 
be shifted from the top-of-book to depth-of-book. BX instead contends 
that market participants and market makers in particular have 
independent and varied motivations for their pricing decisions and 
pricing points and that a directed order program would not affect those 
motivations.\62\ BX argues that a market maker who chooses to quote at 
a price other than the inside is providing value and depth at that 
price when orders trade at multiple price levels as well as when that 
price level becomes the NBBO.\63\
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    \62\ See BX Letter 3, supra note 11, at 2.
    \63\ Id.
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    The Commission has considered the arguments raised by both BX and 
NYSE Euronext. On the one hand, the existing requirement to be quoting 
at the NBBO in order to receive a directed order may incentivize market 
makers to quote tighter spreads, and therefore contribute to more 
efficient markets. On the other hand, BX's proposal to allow Directed 
Market Makers to receive Directed Orders when they are not quoting at 
the NBBO at the time of receipt of the Directed Order may, as BX 
argues, contribute to greater depth in the market, which also could 
contribute to market efficiency. However, BX has not provided 
sufficient information in its proposal to overcome the Commission's 
fundamental concerns about the impact the proposal could have on 
participants' incentives to quote competitively and the potential 
impact on overall prices in the market. For example, a directed market 
maker's incentive to quote in the depth-of-book is likely related to 
the frequency with which marketable orders execute against not just the 
NBBO but also the depth-of-book. BX, however, has not provided any 
analysis regarding the frequency or nature of such marketable orders or 
any data showing the interaction of such orders with the market makers' 
orders or quotes. Accordingly, the Commission does not believe that BX 
has met its burden in demonstrating that this aspect of the proposed 
rule change is consistent with the Act.\64\
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    \64\ 17 CFR 201.700(b)(3).
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C. Application of Heightened Quoting Requirement

    The rules approved by the Commission governing the directed order 
programs of other options exchanges require that directed market makers 
on those exchanges satisfy quoting requirements that are higher than 
those imposed on market makers not receiving directed orders.\65\ BX 
also would impose a heightened quoting requirement on its Directed 
Market Makers that receive Directed Orders. However, unlike the 
directed order rules in place at other options exchanges, BX proposes 
that the heightened quoting requirements for its Directed Market Makers 
apply only after the Directed Market Maker receives its first Directed 
Order in a given month. BX argues that this provision is appropriate 
because a Directed Market Maker does not know if and when it will 
receive a Directed Order, and therefore should not be required to quote 
at a heightened level unless and until it receives a Directed 
Order.\66\ BX also argues that if the Directed Market Maker is not 
quoting, the Directed Order will not execute against such Directed 
Market Maker and thus the Directed Market Maker has an incentive to 
quote competitively in as many series as possible to attract Directed 
Orders. BX then asserts its view that this provision properly balances 
the benefit of receiving enhanced allocations with the obligations of 
heightened quoting.\67\
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    \65\ See C2 Rule 8.17; CBOE Rule 8.13; ISE Rule 811; NYSE Rule 
964NY; NYSEArca Rule 6.88; and Phlx Rule 1014.
    \66\ See BX Letter 2, supra note 9, at 4. The proposal would 
allow a Market Maker to accept Directed Orders at the end of each 
month and then only quote at a heightened level for the remainder of 
that month.
    \67\ Id.
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    The Commission does not believe that BX has sufficiently 
demonstrated why requiring Directed Market Makers to be quoting at a 
heightened level only after receiving a Directed Order would not 
inappropriately upset the balance between a Directed Market Maker's 
obligations (including quoting obligations) and the benefits it 
receives (i.e., its participation entitlement). Accordingly, the 
Commission does not believe that BX has met its burden in demonstrating 
that this aspect of the proposed rule change is consistent with the 
Act.\68\
---------------------------------------------------------------------------

    \68\ 17 CFR 201.700(b)(3).
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IV. Conclusion

    For the reasons set forth above, the Commission does not believe 
that BX has met its burden to demonstrate 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, 
and in particular, Section 6(b)(5) of the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-BX-2013-016) be, and hereby is, 
disapproved.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\69\
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    \69\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-25829 Filed 10-30-13; 8:45 am]
BILLING CODE 8011-01-P


