November 9, 2012.
On March 1, 2012 and April 23, 2012, NASDAQ OMX PHLX LLC (“Phlx” or “Exchange”) filed with the Securities and Exchange Commission (the “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act” or “Act”) 
and Rule 19b-4 thereunder,
two proposed rule changes relating to the transaction fees for certain complex order (“Complex Order”) transactions.
The notice of filing of Phlx-2012-27 was published for comment in the Federal Register on March 15, 2012,
and the notice of filing of Phlx-2012-54 was published for comment in the Federal Register on May 4, 2012.
On April 30, 2012, the Commission suspended the proposals and instituted proceedings to determine whether to approve or disapprove the proposals.
Following the institution of the proceedings, the Commission received a letter from the Exchange in support of its proposals.
On September 11, 2012, the Commission issued a notice of designation of a longer period for Commission action on the proceedings to determine whether to disapprove the proposed rule changes.
On October 24, 2012, the Exchange filed Amendment No. 1 to each of the proposed rule changes. In the amendments, the Exchange proposed to put certain of the fees (for Complex Order executions by Directed Participants 
and Market Makers) 
on a one-year pilot program, and stated that the proposed fees would be operative on December 3, 2012. The Exchange committed to provide publicly available data and data analyses of those fees to the Commission during the pilot.
The Exchange also represented that, prior to and at the time of a complex order transaction, Market Makers, including Directed Participants, are unaware of the identity of the contra-party to the transaction. The Exchange stated that Rule 707 is intended to prohibit coordinated actions between Directed Participants and order flow providers (“OFPs”), and that the Exchange proactively conducts surveillance for, and enforces against, such violations.
The Commission received no comment letters on the proposals. This order approves the proposed rule changes, as modified by Amendments No. 1, and approves, as a one-year pilot program, those fees which the Exchange proposes to implement on a pilot basis.
II. Description of the Proposals
The Exchange's first proposal amended Complex Order fees and rebates for adding and removing liquidity in its Select Symbols.
Specifically, Phlx's proposal: (1) Increased the customer rebate for adding liquidity from $0.30 per contract to $0.32 per contract; (2) created a new rebate for removing liquidity of $0.06 per contract for each contract of liquidity removed by an order designated as a customer Complex Order; (3) amended the fee for removing liquidity for all participants who are assessed such a fee; and (4) created a volume incentive for certain market participants that transact significant volumes of Complex Orders on the Exchange.
Phlx's proposal to amend the Fee for Removing Liquidity increased the Complex Order Fees for Removing Liquidity for the Directed Participant, Market Maker, Firm, Broker-Dealer, and Professional 
categories of market participants. The fee for Directed Participant transactions increased from $0.30 to $0.32 per contract; the fee for Market Makers increased from $0.32 to $0.37 per contract; and the fee for Firms, Broker-Dealers, and Professionals increased from $0.35 to $0.38 per contract.
The proposal also provided a new volume incentive to Market Makers. The Exchange has four categories of Market Makers—Specialists,
—that would all be eligible to receive the volume incentive. Under this proposal, if a Market Maker executes more than 25,000 contracts of Complex Orders each day in a given month, the fees charged for all of that Market Maker's transactions in Complex Orders that remove liquidity, both as a Directed Participant and as a Market Maker, would be reduced by $0.01 per contract for that month.
In its second proposal, the Exchange did not propose to amend any of the fees for the Complex Order Directed Participant and Market Maker Fees for Removing Liquidity in Select Symbols. Rather, the Exchange provided further justification for the differential between the fees paid by Directed Participants and Market Makers.
As discussed more fully below, in its proposals and in its subsequent letter in support of its proposals, the Exchange advanced several arguments as to why the proposal to increase the fee for removing liquidity for Complex Orders to $0.32 per contract for Directed Participants, and to $0.37 per contract for non-directed Market Makers, and the corresponding increase in the differential between these two fees from $0.02 to $0.05 per contract, was not unreasonable or unfairly discriminatory. First, the Exchange stated that Directed Participants enter into payment for order flow agreements (“PFOF”) with OFPs so that OFPs will direct order flow to them to execute against.
According to the Exchange, the reduced fee for Directed Participants recognizes the cost that such Market Makers incur by entering into such PFOF agreements, and the fact that such arrangements bring additional order flow to the Exchange, to the benefit of all Exchange market participants. The Exchange also argued that Directed Participants have higher quoting obligations, and that unlike in the leg markets (i.e., the market for the individual orders that make up a complex order) they do not have a guaranteed allocation for Complex Orders, and that these facts justify the fees. Second, the Exchange stated that the frequency with which Directed Participants execute against orders that are directed to them is such that the effective fee actually paid by such Market Makers is closer to the higher Market Maker rate.
Third, the Exchange stated that the proposed increase in the fee differential from $0.02 to $0.05 per contract will have a negligible impact on Directed Participants and non-directed Market Makers, given the average level of price improvement for customer Complex Orders. Fourth, the Exchange argued that a higher fee differential currently exists on another options exchange that is directly comparable to the Directed Participant/Market Maker differential at issue here. Finally, the Exchange argued that, given the stated policies of the Commission and applicable case law, the Commission should allow competition to determine whether the fees are fair and reasonable.
In its order suspending the two proposals and instituting proceedings to determine whether to approve or disapprove the proposals, the Commission noted several areas of concern. For example, the Commission questioned whether discrimination on the basis of whether a Market Maker has an off-exchange arrangement to pay an OFP to direct its orders to that Market Maker is a “fair” basis for discrimination among exchange members with respect to the fees charged by the Exchange, and whether a flat $0.05 fee differential appropriately reflects potential differences that may exist in payment for order flow arrangements between Market Makers and OFPs.
The Commission also questioned whether the proposed fees and fee differential would have an impact on competition, especially as between Directed Participants and Market Makers.
Finally, the Commission questioned whether the proposed fee changes will affect the quality of execution of customer Complex Orders or broader market quality, and, if so, how and what type of impact will they have.
During the course of the proceedings, the Exchange amended its filings to implement the fee for removing liquidity for Directed Participants and other Market Makers on a one-year pilot basis, and to state that the proposed fees would be operative on December 3, 2012. The Exchange also represented that it would provide the Commission with certain publicly available data and data analyses, on a monthly basis, over the course of the pilot program that would enable the Commission to better evaluate the effects of the fee proposals. As part of the amendment, the Exchange also represented that, prior to and at the time of a complex order transaction, Market Makers, including Directed Participants, are unaware of the identity of the contra-party to the transaction. The Exchange stated that Rule 707 is intended to prohibit coordinated actions between Directed Participants and OFPs, and that the Exchange proactively conducts surveillance for, and enforces against, such violations.
III. Discussion and Commission Findings
After careful consideration, and as discussed below, the Commission finds that the proposed rule changes are consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. In particular, the Commission finds that the proposals are consistent with Section 6(b)(4) of the Act, which requires that the rules of a national securities exchange “provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities;”
Section 6(b)(5) of the Act, which requires, among other things, that the rules of a national securities exchange not be “designed to permit unfair discrimination between customers, issuers, brokers, or dealers;”
and Section 6(b)(8) of the Act, which requires that the rules of a national securities exchange “not impose any burden on competition not necessary or appropriate in furtherance of the purposes of [the Exchange Act].”
The Commission has also considered, pursuant to Section 3(f) of the Act, the proposals' impact on efficiency, competition and capital formation.
Phlx argues in part that the Commission should rely on competitive forces to determine whether the proposed fees are reasonable and not unfairly discriminatory. Phlx states that competition should determine fee changes, noting that the “Congress directed that exchanges' fee changes be deemed immediately effective for the expressed purpose of promoting price competition between markets.” 
In support of this argument, Phlx states that the Commission has “a statutory duty to promote competition, including price competition.” 
Phlx also notes that the DC Circuit Court of Appeals has “blessed” the Commission practice of relying on competitive forces, where possible, to assess the reasonableness of proposed rules,
and that intervention here would contravene the Commission's “stated policy” in this respect.
Phlx represents that the options markets operate in an intensely competitive environment, and that it and the other options exchanges are engaged in an intense competition on price (and other dimensions of competition) to attract order flow from directed and other order flow providers.
As an example, the Exchange notes that it and the Nasdaq Options Market (“NOM,” a sister exchange) have modified options trading fees monthly or even bi-monthly to attract new order flow, retain existing order flow, and regain order flow lost to competitor's price cuts.
Phlx further states that price incentives are the essence of competition, in that they encourage market participants to provide attractive offerings to consumers, they benefit market participants who trade on the Exchange, and, in turn, they benefit consumers who enjoy greater price transparency and execution at lower prices.
Phlx asserts that, in vibrant markets such as the options markets, participants who view one pricing scheme as unpalatable are free to move to another market or markets with favorable pricing.
Phlx states that, given the competitive nature of the options markets, no one exchange has sufficient market power to “raise prices for competitively-traded options in an unreasonable or unfairly discriminatory manner in violation of the* * * Act.” 
According to Phlx, it is the member firms that have market power, as these market participants control the order flow that the options markets compete to attract.
The Commission disagrees with the Exchange's assertion that the existence of competition alone is adequate to determine whether the fees are reasonable, not unfairly discriminatory, and an equitable allocation of fees among members under the Exchange Act. The Commission's market-based approach to evaluating whether certain market data fees are consistent with the Exchange Act incorporates two parts.
First, the Commission examines whether the exchange making the proposal was subject to significant competitive forces in setting the terms of its proposal, including the level of any fees. If the exchange was subject to significant competitive forces in setting the terms of a proposal, the Commission will approve the proposal unless it determines that there is a substantial countervailing basis to find that the terms nevertheless fail to meet an applicable requirement of the Exchange Act or the rules thereunder. The Commission has cited an unfair or unreasonably discriminatory proposal as an example of one such countervailing basis.
Applying this approach to the Exchange's proposal, the Commission finds under the first part of the analysis that the Exchange was subject to significant competitive forces in setting the terms of its proposal. There currently are ten registered national securities exchanges that trade listed options. The Commission has previously found that there is significant competition for order flow in the options markets.
The Exchange provided representations and data supporting the existence of intense competition for order flow among the options exchanges. In particular, the Exchange stated that the trading of options is a highly competitive environment, and that the ability to attract order flow is driven largely by price competition.
The Exchange also stated that member firms control the order flow that options markets compete to attract, and that exchange members, rather than the exchanges, drive competition.
The Exchange produced data showing the market share, based on contract volume, among the options exchanges, which, as of 2012, ranged from approximately less than 1% to 22% for equity options.
Similarly, monthly volume data published by the Options Clearing Corporation indicates that market share for equity options for September 2012 ranged from 0.70% (for NOBO) to 22.97% (for Phlx).
Further, six of the ten options exchanges have rules that provide for the trading of complex orders.
The Exchange produced data regarding market share among the options exchanges for complex orders on a monthly basis from November 2011 to June 2012. For June 1, 2012, the Exchange stated that the market share for complex orders ranged from 3.39% for NYSE Arca, which had 74,486 complex order trades, to 43.79% for ISE, which had 961,040 complex order trades.
Moreover, the volume for complex orders has been increasing over the past few years.
Further, the Commission's finding is based on the representation by the Exchange that the fees at issue apply only to the Select Symbols, which are all equity options that are able to be listed and traded on more than one options exchange, and are therefore subject to competition among the market for order flow.
Under the second part of the analysis, the Commission does not at this time find that there is a substantial countervailing basis to find that the terms of the fees and fee differential fail to meet the requirements of the Exchange Act or the rules thereunder. The Commission notes that it received no comments in opposition to the proposed rule changes. The fees for removing liquidity as proposed distinguish between Directed Participants and all other Market Makers (or other members), and would provide the Directed Participants a lower fee than other Market Makers when the Directed Participants interact with order flow that has been directed to them. The Exchange argues in part that Directed Participants that execute against order flow in the complex market that has been directed to them do not have a 40% guaranteed allocation, unlike in the leg market,
and that the reduced fee for Directed Participants is an attempt to confer an additional benefit on Directed Participants for the value they provide in bringing order flow to the Exchange. The Exchange also argues that increased order flow provides better execution quality on the Exchange because customers enjoy greater price transparency and executions at lower prices, and that Market Makers to whom order flow is directed still must compete with other Exchange participants to interact with that order flow to receive the benefits of such arrangements.
According to the Exchange, this increased order flow, and corresponding greater execution quality, benefits all market participants.
The Commission has previously approved as consistent with the Act rules of exchanges that provide directed Market Makers a 40% guaranteed allocation when they interact with directed order flow, based upon their status as directed Market Makers.
Likewise, pursuant to the proposals at issue here, Directed Participants on Phlx would be charged a lower fee when they interact with order flow directed to them, based on their status as Directed Participants.
When approving the proposals that provided a guaranteed allocation to directed market makers, the Commission found that the guaranteed allocation for directed market makers would not affect the incentives of the trading crowd to compete aggressively for orders based on price.
Here, the Commission believes that the potential impact of a guaranteed allocation on competition may be distinguished from the potential impact of the reduced transaction fee on competition. Specifically, the guaranteed allocation does not provide directed market makers an explicit subsidy—in the form of lesser per contract fees—over other market makers that are competing to execute against the same order flow. Rather, the guaranteed allocation scheme allocates portions of orders to other Market Makers who are at the same price as the directed market maker, thus protecting the incentive of other market makers to compete with directed market makers on price. In contrast, assessing a lesser transaction fee on Directed Participants than other Market Makers when the Directed Participants interact with order flow directed to them may allow Directed Participants to execute against Complex Orders at more aggressive prices than other market makers, which may reduce the incentive and ability of such other market makers to compete with Directed Participants on price.
The Commission has carefully considered the potential impact of the fees for removing liquidity on Directed Participants and other Market Makers and the $0.05 fee differential on competition between Directed Participants and other Market Makers that are competing to execute against the same order flow, and on the extent of price improvement provided to directed customer Complex Orders. The data provided by Phlx does not show any statistical significant adverse impact of the proposed fee and fee differential on the competitiveness of the market for directed customer Complex Orders on Phlx, or the extent of price improvement for directed customer Complex Orders.
However, the suspended fees that are at issue were only in place for two months and thus were only analyzed over that period.
Phlx has filed an amendment to its filing to, among other things, specify that the portion of the proposed rule change relating to execution fees for Complex Orders for Directed Participants and other Market Makers, and the accompanying $0.05 fee differential, will be operative on a one-year pilot basis, and that such fees will be operative on December 3, 2012. Phlx also has committed to provide the Commission, on a monthly basis, with publicly available data and data analyses studying the impact of the fees for removing liquidity for complex orders for Directed Participants and other Market Makers upon inter and intra-market competition, and upon market quality. The Exchange has represented that it would provide such information as the Commission may request regarding this fee pilot, including information with respect to rates of order interaction by Directed Participants and Market Makers with Customer Complex Orders and rates of price improvement for Complex Orders.
This data and analysis will allow the Exchange and the Commission to further evaluate during the course of the pilot program the impact of the fees for removing liquidity for Directed Participants and other Market Makers and the $0.05 fee differential on competition between Directed Participants and other Market Makers and the extent of price improvement for Complex Orders over a longer time period with a larger data set.
For these reasons, the Commission finds that the proposed rule changes, each as modified by Amendment No. 1, are consistent with the Act. The Commission's finding takes into account that Directed Participants are subject to heightened quoting obligations compared to other Market Makers that are not Directed Participants,
and that the fact that whether a customer Complex Order is a directed order or not is not known to any Market Maker, including Directed Participants, prior to execution.
In its original filing, the Exchange also pointed to the existence of non-exchange sponsored PFOF arrangements as a basis for the fees and fee differential. Specifically, Phlx argued that the fee differential is fair, equitable and not unfairly discriminatory because it is intended “to * * * reflect the increased costs that are incurred by such Market Makers that enter into order flow arrangements at a cost and without the benefit of a guaranteed allocation.” 
In support of its argument, Phlx has represented that it is aware that non-exchange-sponsored PFOF arrangements exist, and that the rates paid by Market Makers under these arrangements, in many cases, “exceed [Phlx's] own exchange-sponsored payment for order flow fee and also exceed the rebates that [Phlx] provides for adding or removing liquidity from the exchange.” 
However, Phlx also represented that it “does not compile data on the exact prices that Market Makers pay third-party order flow providers for directed order flow * * *.” 
Phlx has not produced any data with respect to non-exchange-sponsored payment for order flow arrangements, and has represented to Commission staff that it does not have such data.
The Commission does not believe that this argument provides a reasonable basis to find that the fees and fee differential are consistent with the Act. As outlined above, pursuant to this argument, Phlx would be setting its fees, and discriminating among market participants, based on the existence of non-exchange sponsored PFOF arrangements. The record, however, does not contain any representations regarding the amounts of payments made by Directed Participants pursuant to such arrangements or whether such payments are made, whether these off-exchange PFOF arrangements are standardized, and whether the terms and amounts are the same between different OFPs and Directed Participants. As such, the Exchange has not substantiated the details of such off-exchange PFOF arrangements. The Commission believes it is likely that the terms of such arrangements could vary considerably between different Directed Participants and OFPs. Essentially, pursuant to this argument, Phlx could be discriminating in its fees for a specified amount based on payments potentially made off-exchange that may vary widely. The Commission therefore does not believe that this argument provides a basis to support a finding that the fees and fee differential are reasonable, equitably allocated, and not unfairly discriminatory. Nevertheless, for the reasons discussed above, the Commission finds that the proposed rule changes are consistent with the Act.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods:
- 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 Numbers SR-Phlx-2012-27 and SR-Phlx-2012-54. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for 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 10:00 a.m. and 3:00 p.m. Copies of the filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Numbers SR-Phlx-2012-27 and SR-Phlx-2012-54 and should be submitted on or before December 7, 2012.
V. Accelerated Approval of Proposed Rule Changes, as Modified by Amendments No. 1
Amendments No. 1 revised the proposed rule changes to, among other things, specify that the portion of the proposed rule change relating to fees for removing liquidity for Complex Orders for Directed Participants and other Market Makers, and the accompanying $0.05 fee differential, will be operative on a one-year pilot basis, and that such fees would be operative on December 3, 2012. Phlx also committed to provide the Commission, on a monthly basis, with publicly available data and data analyses studying the impact of the fees for removing liquidity for complex orders for Directed Participants and other Market Makers upon inter and intra-market competition, and upon market quality. The Exchange represented that it would provide such information as the Commission may request regarding this fee pilot, including information with respect to rates of order interaction with Customer Complex Orders and rates of price improvement. Receiving data and analysis from the Exchange during the duration of the pilot period will allow the Commission (and the Exchange) to continue to assess the impact, if any, of the proposed rule changes during the pilot period. Accordingly, the Commission finds good cause, pursuant to Section 19(b)(2) of the Act,
for approving the proposed rule changes, as modified by Amendments No. 1, prior to the 30th day after the date of publication of notice in the Federal Register.
For the foregoing reasons, the Commission finds that the proposed rule changes, as modified by Amendments No. 1, are consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange, and, in particular, with Sections 6(b)(4), 6(b)(5), and 6(b)(8) of the Act.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule changes (SR-Phlx-2012-27 and SR-Phlx-2012-54), as modified by Amendments No. 1, be, and hereby are, approved. With respect to the fees for executions of Complex Orders by Directed Participants and Market Makers, such fees are approved on a one-year pilot basis, with such fees being operative on December 3, 2012.
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.
Kevin M. O'Neill,
[FR Doc. 2012-27819 Filed 11-15-12; 8:45 am]
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