Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”)
The Exchange is proposing to establish a payment for order flow program as follows:
• Fees on transactions with Public Customer;
• Fees on transactions with Non-Customers
• Fees on transactions with away market makers.
There will not be any fees on transactions in which all parties are PMMs and CMMs. The Exchange will establish the specific fees in a separate rule filing submitted pursuant to Section 19(b)(3)(A) of the Act.
The Exchange also will have the flexibility to establish multi-tiered fees. These tiers can be based on such factors as the overall trading activity of an option, the Exchange's market share in an option, or any other objective factor. If the Exchange establishes multi-tiered fees, the Exchange's fee filing will specify each of those fees.
In its filing with the Commission, the ISE included statements concerning the purpose of, and basis for, the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. The ISE has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of the statements.
The purpose of the proposed rule change is to establish the structure for an ISE payment-for-order-flow program. This is a competitive response by the Exchange to similar programs of the other options exchanges. The proposal has two parts: establishing the structure of a fee to fund a payment-for-order-flow program; and establishing how the funds the fees generate will be used to pay for order flow.
The ISE states that the possible lower fees on Non-Customers reflect a balancing of the competitive interests that currently exist in the options markets. The Exchange seeks to encourage market makers to provide significant size for Non-Customer orders. If the payment-for-order flow fee is set at too high a level, however, PMMs and CMMs may not provide sufficient size to attract these orders to the Exchange. Thus, the Exchange believes that it is important to establish a structure that will allow it to establish a balance between generating revenue to pay for order flow and attracting Non-Customer order flow.
In addition, the Exchange is proposing a structure that could distinguish between orders of away market makers and other Non-Customers. While the fee could be lower on transactions with away market makers than with other Non-Customers, it could not be higher. This distinction recognizes certain unique aspects of away market maker order flow. In particular, pursuant to the intermarket options linkage plan
The proposed rule change also provides that there will not be a fee on transactions in which all parties are PMMs and CMMs. Transactions between market makers are an important aspect of the ISE's price-discovery model. These trades often occur when market makers have different views on an options price and their quotes interact until a “price equilibrium” is established. In addition, these trades could occur as market makers hedge or rebalance their positions. The Exchange believes that it would be inappropriate to “tax” these trades. Such a “tax” could create incentives to avoid this type of trading, which could harm the overall depth, liquidity, and pricing efficiency of the ISE's market.
Finally, the proposal would permit the Exchange to establish multiple tiers of fees. The Exchange would define the tiers pursuant to objective criteria, including but not limited to the overall activity in an option and the Exchange's market share in an option. This is intended to provide the ISE with as much flexibility as possible in collecting funds to pay for order flow in a manner consistent with the Exchange's overall goal of creating incentives for market makers to provide deep and liquid markets.
With respect to members who receive payments for their order flow, the Exchange will be issuing appropriate circulars to its members emphasizing their disclosure and best execution obligations. The Exchange also will be providing to members various reports and other information demonstrating the quality of executions that they receive on the Exchange.
The basis for this proposed rule change is the requirement under Section 6(b)(5) of the Act
The ISE believes that payment-for-order-flow raises significant competitive issues. In the ISE's view, when market makers pay broker-dealers for their order flow, the true cost of executing orders is obscured, imposing a burden on price competition in the market. Specifically, the ISE believes that it is difficult to compete for order flow when undisclosed payments are influencing order routing decisions.
Furthermore, the ISE believes that these competitive issues are compounded when exchanges establish payment-for-order-flow programs. In the ISE's view, not only do the payment programs impede price discovery and competition on an intermarket basis, but these programs also can raise intramarket competitive issues. In this regard, the ISE believes that market makers on an exchange should be encouraged to compete vigorously within their markets for order flow. Exchange-mandated payment-for-order-flow programs require these competitors to act jointly in paying broker-dealers for their orders, however. The ISE believes that this mandated“tax” on transactions may well adversely affect the ability of individual market makers to compete as vigorously as possible for order flow through aggressive quotations, thus harming intra market price competition. Moreover, in the ISE's view, to the extent that market makers do “compete” by paying for order flow, such payments may or may not flow through to the ultimate investor. In contrast, aggressive quotation competition clearly would flow through to investors.
Notwithstanding these concerns, the ISE believes that it must establish a level playing field on which it can compete with the other options exchanges, all of which have developed their own payment for order flow programs. Accordingly, the Exchange believes that this proposed rule change does not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.
As noted below, the Commission has permitted payment-for-order-flow programs on all four competing options exchanges to take effect pursuant to effective-on-filing rule changes. While the Commission has the authority to abrogate those filings, it has not exercised that authority.
The Exchange has not solicited, and does not intend to solicit, comments on this proposed rule change. The Exchange has not received any unsolicited written comments from members or other interested parties.
Within 35 days of the date of publication of this notice in the
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. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549–0609. 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 inspection and copying in the Commission's Public Reference Room. Copies of the filing will also be available for inspection and copying at the principal office of the ISE. All submissions should refer to File No. SR–ISE–00–10 and should be submitted by November 17, 2000.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority.