May 22, 2017.
On February 10, 2017, the Chicago Stock Exchange, Inc. (“CHX” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) 
and Rule 19b-4 thereunder,
a proposed rule change to adopt the CHX Liquidity Enhancing Access Delay (“LEAD”). The proposed rule change was published for comment in the Federal Register on February 21, 2017.
On April 3, 2017, the Commission designated a longer period within which to approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether the proposed rule change should be disapproved.
The Commission received eleven comment letters on the proposed rule change, including a response from the Exchange.
This order institutes proceedings under Section 19(b)(2)(B) of the Exchange Act 
to determine whether to approve or disapprove the proposed rule change.
II. Summary of the Proposal
The Exchange proposes to adopt the LEAD, which would subject all new incoming orders,
cancel and cancel/replace messages to a 350-microsecond intentional access delay, provided that certain types of messages would not be subject to the delay: (1) New incoming orders submitted by LEAD Market Makers (“LEAD MM”), a new class of CHX Market Maker 
with heightened quoting and trading obligations (referred to collectively as the “minimum performance standards”), which would be immediately ranked on the CHX book without executing against any resting orders on the CHX book; (2) certain cancel messages related to resting orders that were submitted by LEAD MMs; (3) cancel/replace messages related to resting orders that were submitted by LEAD MMs (except that any part of the replace portion of the order that would immediately execute against a resting order would be intentionally delayed); and (4) the portion of a routable order that is to be routed away, regardless of who submitted the routable order. A message will be subject to a 350 Start Printed Page 24413microsecond delay after initial receipt by the Exchange (“Fixed LEAD Period”), but will only be processed after the Exchange's matching system
has evaluated and processed, if applicable, all messages in the security received by the Exchange during the Fixed LEAD Period. A delayed message will retain its original sequence number and may be delayed only once. The LEAD would be applied to all securities traded on the Exchange throughout the trading day.
The Exchange states that the LEAD is designed to enhance displayed liquidity and price discovery by minimizing the effectiveness of “latency arbitrage” strategies,
which the Exchange says diminish displayed liquidity and impair price discovery. According to the Exchange, latency arbitrage is and has been effected at CHX by low-latency market participants that leverage microsecond speed advantages to take resting liquidity at stale prices from the CHX limit order book. Specifically, in 2016, the Exchange experienced a decline in volume in the SPDR S&P 500 trust exchange-traded fund (“SPY”), which the Exchange attributes to latency arbitrage activity in SPY first observed at CHX in January 2016. Between January and July 2016, the Exchange found that SPY latency arbitrage activity caused CHX liquidity providers to dramatically reduce displayed trading interest in SPY (and at times withdraw from the market altogether).
The Exchange believes that the LEAD would not materially impact the ability of liquidity takers not engaged in latency arbitrage, such as retail investors, to access displayed liquidity at CHX.
The Exchange also contends that, to the extent a sophisticated market participant seeks to take displayed liquidity pursuant to better or different information (as opposed to the same information exploited by latency arbitrageurs), the LEAD would be too short to have an incrementally negative impact on such non-latency arbitrage strategies.
A LEAD MM would be required to meet the proposed minimum performance standards in return for undelayed access to submit liquidity providing orders and to cancel its resting orders. The proposed minimum performance standards require:
- a LEAD MM to satisfy the Quotation Requirements and Obligations prescribed under current CHX Article 16, Rule 4(d),
except that the Designated Percentages described under current Article 16, Rule 4(d)(2)(B) shall be halved; 
- a LEAD MM to maintain a “Monthly Average NBBO Quoting Percentage,” as defined in proposed CHX Article 16, Rule 4(f)(2)(B)(iv), in each of the securities assigned to the LEAD MM (“LEAD MM Securities”), of at least 10% over the course of a calendar month; 
- a LEAD MM's Qualified Executions; 
in each of its LEAD MM Securities must comprise on an equally-weighted daily average at least 2% of all Qualified Executions in the same security over the course of a calendar month; 
- that at least 80% of the LEAD MM's Qualified Executions in each of its LEAD MM Securities must result from its resting orders that originated from the corresponding LEAD MM trading account 
over the course of a calendar month.
The proposed rule change also establishes the procedure for CHX to designate LEAD MMs in a security. Only a Market Maker could apply to be a LEAD MM in one or more securities,
and Market Makers must receive written approval from the Exchange to be assigned securities as a LEAD MM. LEAD MMs would be selected by the Exchange based on factors including, but not limited to, experience with making markets in securities, adequacy of capital, willingness to promote the Exchange as a marketplace, issuer preference, operational capacity, support personnel and history of adherence to Exchange rules and securities laws. Current Article 16, Rules 2(c)-(e) govern Market Maker withdrawal from assigned securities, and would apply to LEAD MMs and LEAD MM Securities. The Exchange could approve at its discretion more than one LEAD MM to be assigned to any LEAD MM Security and limit the number of LEAD MMs assigned to any security.
Proposed CHX Article 16, Rule 4(f)(3)(D) outlines requirements regarding LEAD MM trading accounts and, according to the Exchange, facilitates the ability of the Exchange to monitor compliance with the proposed minimum performance standards. The Exchange would review each LEAD MM's quoting and trading activity on a monthly basis to determine whether the LEAD MM has met the minimum performance standards.
A LEAD MM's failure to meet the minimum performance standards on any given month would result in the Exchange: (1) Suspending or terminating a LEAD MM's registration as a Market Maker pursuant to current Article 16, Rule 1(d); or (2) suspending or terminating assignment to a LEAD MM Security pursuant to proposed CHX Article 16, Start Printed Page 24414Rule 4(f)(3)(A).
These proposed provisions would not limit any other power of the Exchange to discipline a LEAD MM pursuant to other CHX rules.
III. Summary of the Comments
The Commission has received eleven comments on the proposed rule change, including a response letter from the Exchange.
Two commenters expressed support for the proposal,
and eight commenters expressed opposition to the proposal.
Some commenters questioned whether, as asserted by CHX, latency arbitrage is to blame for the decline in CHX's market share, and whether the LEAD would solve the purported problem.
One commenter questioned CHX's assertion that there is structural bias against displayed liquidity, and the need for an asymmetrical remedy.
Another commenter opined that the proposed rule change is overbroad because the proposed LEAD is a systemic solution to a problem—namely a decline in CHX's market share in one security—that CHX has not demonstrated to be market-wide.
In addition, a commenter questioned whether CHX could address what it perceives as latency arbitrage by improving its technology to reduce the time to cancel for liquidity providers.
Another commenter suggested other ways to confront latency arbitrage, including that the Exchange could move its servers closer to the Chicago Mercantile Exchange's (“CME”) servers or to New Jersey, apply a delay to messages coming from CME's data centers, implement a random delay for everyone, or prohibit latency arbitrage by rule.
Several commenters discussed the potential impact of the proposal on displayed liquidity and price discovery. Two commenters asserted that the LEAD would enable liquidity providers to improve displayed liquidity.
Six commenters, however, expressed concern that the LEAD could deteriorate the accessibility of quotes and overall market quality.
For example, one commenter predicted that, while overall spreads and liquidity may improve, the increased liquidity would be more conditional and less accessible.
In addition, a commenter predicted that spreads made by “real” liquidity providers—as distinguished from “fleeting” quotes submitted by LEAD MMs—would widen.
In response, the Exchange asserted that the proposal would promote tighter spreads and larger size, and that there is no evidence that it would result in CHX quotes being less accessible to “natural” buyers and sellers.
In addition, some commenters stated that the LEAD would impinge upon price discovery across the national market system.
Some commenters noted that an asymmetric delay on TSX Alpha, a Canadian exchange, degraded overall market quality, harmed institutional order routers, and increased effective spreads.
One commenter noted that while quoted depth increased on TSX Alpha, the exchange did not demonstrate tighter spreads, and the accessibility of quotes significantly degraded.
In addition, a commenter asserted that the only counterbalance to the negative impact on market quality caused by an asymmetric delay (such as that exhibited due to TSX Alpha) would be coupling it with “robust and rigorous” affirmative obligations for those benefitting from the delay.
In response, the Exchange asserted that the TSX Alpha delay is materially different from LEAD because it is randomized and, unlike CHX, TSX Alpha utilizes an inverted maker-taker model.
The Exchange also observed that TSX Alpha does not require its liquidity providers to meet heightened requirements designed to enhance market quality.
One commenter asserted that the indeterminacy of the proposed delay may result in the LEAD producing delays that are not de minimis.
In response, the Exchange stated that processing delays and message queuing currently exists in every market.
The Exchange also asserted that these delays would not provide LEAD MMs with more than a 350 microsecond window to adjust or cancel their resting orders at CHX.
Several commenters stated that the LEAD would unfairly discriminate in favor of the LEAD MMs.
Specifically, commenters asserted that the LEAD would harm market participants seeking to access liquidity provided by LEAD MMs as the LEAD MMs may alter their prices while incoming orders are being delayed.
In addition, a commenter stated that the LEAD would give LEAD MMs an unfair advantage.
One commenter asserted that the LEAD could make it more difficult for non-LEAD MMs to quote better prices at larger size.
Two commenters stated that the LEAD would unfairly discriminate against market participants that are primarily liquidity takers, such Start Printed Page 24415as retail investors or institutions.
Another commenter expressed concern that, unlike other examples of “permissible” discrimination, the LEAD would affect the regulatory mechanics of trading because, in some cases, traders would be required to route orders to the Exchange pursuant to Rule 611 of Regulation NMS.
In addition, one commenter asserted that the delay would only benefit market participants who become LEAD MMs and subscribe to the CME's data feeds.
In response, CHX stated that the LEAD would discriminate on fair terms because it is designed to correct the current asymmetry that CHX says currently exists in the market.
In addition, CHX asserted that the LEAD would reduce the cost of providing liquidity to the LEAD MMs, which CHX asserted would result in efficient price discovery for retail and institutional investors.
Other commenters expressed concern that the proposal would be unfairly discriminatory because only firms selected by CHX as LEAD MMs would be given the speed advantage,
and LEAD MMs would be named based on subjective criteria.
CHX responded that the LEAD MM factors are designed to forecast how well that applicant would perform as a LEAD MM if approved.
CHX further noted that the criteria are “virtually identical” to the criteria under Bats BZX's rules for its lead market maker program.
Several commenters commented on the proposed minimum performance standards. Two commenters expressed support for the proposed minimum performance standards.
One of these commenters asserted that the proposal would effectively couple heightened quoting and trading requirements with the ability to adequately manage the heightened risks of such requirements.
Other commenters expressed concern that the minimum performance standards may not be adequate to justify the benefits that LEAD MMs would receive under the proposal.
Two commenters suggested that CHX should provide data regarding the materiality of the minimum performance standards, how they will improve market quality, and whether CHX market makers already satisfy these criteria.
In response, the Exchange asserted that the proposed minimum performance standards are “substantial and proportionate to the benefits conferred upon LEAD MMs,” and that they would minimize the risk of incremental quote fading and other non-bona fide liquidity provision strategies.
Further, the Exchange stated that the minimum performance standards are appropriate in light of the requirements imposed upon and benefits incurred by market makers on other exchanges.
Some commenters suggested that the LEAD could increase the risk of manipulative activity. One commenter argued that the LEAD would enable intra-exchange latency arbitrage because CHX would impose neither negative obligations on its LEAD MMs nor information barriers to segregate LEAD market making from other proprietary trading.
Another commenter expressed concern that the LEAD would frustrate strategies that involve taking prices across multiple venues by giving extra time to LEAD MMs to pull their quotes in the middle of a multi-venue order.
The Exchange responded that sophisticated order routing strategies would minimize incremental leakage, and that the LEAD is much shorter than the time that it would take for information regarding a CHX routed order that is executed away to be consumed and processed by the LEAD MM.
One commenter asserted that the LEAD would unduly burden competition among CHX members and among national securities exchanges.
Another commenter stated that the LEAD would alter the competitive balance in the market by benefitting only LEAD MMs.
In addition, some commenters asserted that the LEAD may be inconsistent with the “firm quote” provisions of Rule 602 of Regulation NMS (“Quote Rule”) because commenters asserted that it would allow liquidity providers to back away from their quotes.
The Exchange responded that the LEAD would not violate the Quote Rule because the duty of a broker or dealer to stand behind its quote would not vest because the LEAD would prevent the liquidity provider from receiving (i.e., being presented with) a marketable contra-side order.
Several commenters asserted that the adoption of the LEAD could be inconsistent with CHX's protected quotation status under Regulation NMS.
In particular, some commenters asserted that by providing LEAD MMs with a structural advantage, the LEAD would frustrate the purposes of Rule 611 by impairing fair and efficient access to an exchange's quotations.
In response, the Exchange stated that it believes that LEAD would be a de minimis delay so short as not to: (1) Frustrate the purposes of the Rule 611 by impairing fair and efficient access to the Exchange's quotations; and (2) neither provide an incremental advantage other than neutralizing structural bias nor permit a LEAD MM to back away from a quote on a quotation-by-quotation basis.
Certain commenters also asserted that the LEAD would result in unfair allocation of consolidated market data revenue by generating an increase in quoting, but not necessarily trading, on the Exchange.
The Exchange responded that the LEAD would not encourage non-bona fide quote activity for the purpose of earning rebates because quotes cancelled within the 350-microsecond LEAD would not be eligible for market data revenue rebates, Start Printed Page 24416and cancellation of such quotes could result in the CHX participant being assessed an order cancellation fee.
IV. Proceedings To Determine Whether To Approve or Disapprove SR-CHX-2017-04 and Grounds for Disapproval Under Consideration
The Commission is instituting proceedings pursuant to Section 19(b)(2)(B) of the Exchange Act 
to determine whether the proposed rule change should be approved or disapproved. Institution of such proceedings is appropriate at this time in view of the legal and policy issues raised by the proposed rule change. Institution of proceedings does not indicate that the Commission has reached any conclusions with respect to any of the issues involved. Rather, as stated below, the Commission seeks and encourages interested persons to provide comments on the proposed rule change.
Pursuant to Section 19(b)(2)(B) of the Exchange Act,
the Commission is providing notice of the grounds for disapproval under consideration. The Commission is instituting proceedings to allow for additional analysis of the proposed rule change's consistency with: (1) Section 6(b)(5) of the Exchange 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; 
(2) Section 6(b)(8) of the Exchange 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; 
and (3) Section 11A of the Exchange Act.
IV. Procedure: Request for Written Comments
The Commission requests that interested persons provide written submissions of their views, data, and arguments with respect to the issues identified above, as well as any other concerns they may have with the proposal. In particular, the Commission invites the written views of interested persons concerning whether the proposal is consistent with Sections 6(b)(5), 6(b)(8), and 11A of the Exchange Act, any other provision of the Exchange Act, or any other rule or regulation under the Exchange Act. Although there do not appear to be any issues relevant to approval or disapproval that would be facilitated by an oral presentation of views, data, and arguments, the Commission will consider, pursuant to Rule 19b-4, any request for an opportunity to make an oral presentation.
Interested persons are invited to submit written data, views, and arguments regarding whether the proposal should be approved or disapproved by June 16, 2017. Any person who wishes to file a rebuttal to any other person's submission must file that rebuttal by June 30, 2017. The Commission asks that commenters address the sufficiency of the Exchange's statements in support of the proposal, in addition to any other comments they may wish to submit about the proposed rule change. In particular, the Commission seeks comment on the following:
1. Would the proposed minimum performance standards for LEAD MMs enhance market quality? Why or why not? What metrics would help determine any enhancement to market quality? How should enhancements to market quality be measured with the delay in effect?
2. How would the proposal affect price volatility during stressed trading conditions?
3. How would the proposal affect transaction costs for retail and institutional investors?
4. How would the proposal affect an institutional investor's experience providing liquidity and removing liquidity on CHX?
5. Would the proposal provide an unfair advantage to LEAD MMs providing liquidity vis-à-vis other liquidity providers and in particular when the price of a security moves?
6. Do commenters agree with the Exchange's assertion that the proposed rule change would increase displayed liquidity on the Exchange?
7. Do the obligations for LEAD MMs to comply with the proposed minimum performance standards justify the LEAD MMs' speed advantage?
8. According to several commenters, liquidity provided by LEAD MMs would be “fleeting” because they could update their quotations while incoming orders are delayed. Do commenters agree? If so, what are commenters' views on how significant “fleeting” liquidity would be in comparison to the overall liquidity provided on the Exchange?
9. How would the proposal affect the national market system if exchanges with a larger percentage of overall trading volume were to adopt a similar proposal? In particular, how would the proposal affect market quality?
10. One of the stated goals of the proposal is to minimize the effectiveness of latency arbitrage strategies. What metrics would help determine if latency arbitrage is currently a problem on CHX? Is 350 microsecond necessary to minimize the effectiveness of latency arbitrage strategies? Should the delay be shorter or longer to accomplish this goal? Is the 350 microsecond delay appropriate for trading at both CHX's Chicago data center and its East Coast data center? Why or why not?
11. Does the proposal's protection against latency arbitrage strategies for LEAD MMs warrant the benefits of the delay?
12. Is the delay short enough that it would not harm liquidity takers or providers other than those engaging in latency arbitrage?
13. What are commenters' views on how the proposal would affect liquidity providers on CHX other than LEAD Market Makers as well as liquidity providers on other markets?
Comments may be submitted by any of the following methods:
- Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.
All submissions should refer to File Numbers SR-CHX-2017-04. 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 Start Printed Page 24417Commission, 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 these filings 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 Number SR-CHX-2017-04 and should be submitted on or before June 16, 2017. Rebuttal comments should be submitted by June 30, 2017.
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.
Eduardo A. Aleman,
[FR Doc. 2017-10807 Filed 5-25-17; 8:45 am]
BILLING CODE 8011-01-P