[Federal Register Volume 79, Number 68 (Wednesday, April 9, 2014)]
[Notices]
[Pages 19680-19683]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-07892]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-71863; File No. SR-ISE-2013-72]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Order Granting Approval of Proposed Rule Change, as Modified by
Amendment No. 1, to More Specifically Address the Number and Size of
Counterparties to a Qualified Contingent Cross Order
April 3, 2014.
I. Introduction
On December 18, 2013, the International Securities Exchange, LLC
(the ``Exchange'' or the ``ISE'') filed with the Securities and
Exchange Commission (``Commission''), pursuant to Section 19(b)(1) of
the Securities Exchange Act of 1934 (the ``Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change notice to amend Rules 504 (Series
of Options Contracts Open for Trading) and 715 (Types of Orders) to
more specifically address the number and size of counterparties to a
Qualified Contingent Cross Order (``QCC Order''). The proposed rule
change was published for comment in the Federal Register on January 7,
2014.\3\ On February 18, 2014, the Commission extended the time period
for Commission action to April 7, 2014.\4\ The Commission received
three comment letters on the proposal.\5\ On April 2, 2014, the
Exchange responded to the comment letters.\6\ Additionally, on April 2,
2014, the Exchange submitted an amendment to the proposed rule
change.\7\ This order approves the proposed rule change, as modified by
Amendment No. 1.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 71208 (December 31,
2013), 79 FR 0881 (January 7, 2014).
\4\ See Securities Exchange Act Release No. 71560 (February 18,
2014), 79 FR 10218 (February 24, 2014).
\5\ See letters to Elizabeth M. Murphy, Secretary, Commission,
from Janet McGuiness, Executive Vice President, NYSE Euronext, dated
March, 11, 2014 (``NYSE Letter''), Darren Story, CFA, dated March
14, 2014 (``Story Letter''), and Doug Patterson, CCO, CutlerGroup,
LP, dated March 28, 2014 (``Cutler Letter'').
\6\ See letter to Elizabeth M. Murphy, Secretary, Commission,
from Michael J. Simon, Secretary and General Counsel, ISE, dated
April 2, 2014 (``ISE Response'').
\7\ The Commission notes that Amendment No. 1 is not subject to
notice and comment because it does not alter the substance of the
proposed rule change or raise any novel regulatory issues, but
rather describes how the Exchange surveils QCC Orders. See Section
III below.
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II. Background
As originally approved on ISE, a QCC Order was required to be
comprised of an order to buy or sell at least 1,000 contracts that is
identified as being part of a qualified contingent trade (``QCT''),
coupled with a contra-side order to buy or sell an equal number of
contracts.\8\ Following discussions regarding the QCC Order with
Commission staff, the Exchange learned that Commission staff
interpreted the Exchange's rules relating to QCC Orders to permit only
a single order on the originating side of the QCC Order and a single
order on the contra-side, with each such order comprised of a single
party and meeting the 1,000 contract minimum size requirement. In a
Regulatory Information Circular published by the Exchange on November
25, 2013, the Exchange explained that it had always interpreted the QCC
Order definition to mean that a QCC Order must be comprised of an
unsolicited order to buy or sell at least 1,000 contracts that is
identified as part of a QCT, coupled with a contra-side order that
could be made up of multiple orders, each of which could be less than
1,000 contracts.\9\ ISE also stated that it would seek to amend its
rules governing QCC Orders to codify its interpretation in its
rules.\10\
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\8\ See Securities Exchange Act Release No. 63955 (February 24,
2011), 76 FR 11533 (March 2, 2011) (SR-ISE-2010-73) (``Original QCC
Approval Order'').
\9\ See ISE Regulatory Information Circular 2013-022 (November
25, 2013).
\10\ Id.
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On December 18, 2013, the Exchange filed two proposed rule changes
with the Commission. In addition to this filing, the Exchange filed SR-
ISE-2013-71, a proposed rule change for immediate effectiveness to
amend the definition of a QCC Order such that it must involve a single
order for at least 1,000 contracts on the originating side,\11\
[[Page 19681]]
but may consist of multiple orders on the opposite, contra-side, so
long as each contra-side order is for at least 1,000 contracts.\12\ In
that filing, the Exchange explained,
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\11\ In the case of Mini Options, the minimum size is 10,000
contracts.
\12\ See Securities Exchange Act Release No. 71183 (December 24,
2013), 78 FR 79721 (December 31, 2013) (SR-ISE-2013-71).
It was always the Exchange's intent and understanding when
drafting the rule text that a QCC Order could involve multiple
contra-parties of the QCC trade when the originating QCC Order
consisted of at least 1,000 contracts. However, the rule language
addressing the contra-side of a QCC Order is drafted from the
perspective of how the QCC Order gets entered into the ISE system.
Specifically, the contra-side order to a QCC Order will always be
entered as a single order, even if that order consists of multiple
contra-parties who are allocated their portion of the trade in a
post-trade allocation. Notwithstanding the foregoing, the literal
wording of the current QCC Order rule could result in a more limited
interpretation of the rule. Therefore, the Exchange now proposes to
make it clear that a QCC Order must involve a single order for at
least 1,000 contracts on the originating side, but that it may
consist of multiple orders on the opposite, contra-side, so long as
each of the contra-side orders is for at least 1,000 contracts.\13\
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\13\ Id. at 79722.
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III. Description of the Proposed Rule Change
In this filing, the Exchange proposes to remove the requirement
that contra-side orders of QCC Orders be for at least 1,000 contracts
each, thus permitting multiple contra-side orders on a QCC Order with a
total number of contracts equaling the originating order size, but
without any size requirement for such contra-side orders. Under this
proposal, the requirements for the QCC Order's originating order remain
unchanged, and thus would require the originating order to be a single
order for a single party of at least 1,000 contracts, and the QCC Order
must also continue to satisfy all other requirements of a QCC Order
under the Exchange's rules.
The Exchange believes that removing the size limit placed on
contra-parties to QCC Orders may increase liquidity and, potentially,
improve the prices at which QCC Orders get executed, as the Exchange
states that the ability for market participants to provide liquidity in
response to large sized orders is directly proportional to the size and
associated risk of the resulting position. As support, the Exchange
states that smaller sized trades are often done at a better price than
larger sized trades, which convey more risk. The Exchange believes that
the ability to pool together multiple market participants to
participate on the contra-side of a trade for any size, as opposed to
only allowing market participants to participate for a minimum of 1,000
contracts, would have a direct and positive impact on the ability of
those market participants to provide the best price as they compete to
participate in the order without being compelled to provide liquidity
with a large minimum quantity. Further, the Exchange states that
allowing several participants to offer liquidity to a QCC Order serves
to ensure that the order receives the best possible price available in
the market and argues that restricting interaction to only participants
who are willing to trade a minimum of 1,000 contracts simply guarantees
an inferior price because a trade will be limited to few liquidity
providers who are taking on more risk as opposed to multiple liquidity
providers being able to share the overall risk and trade at a better
price.
In the proposal, the Exchange stresses that the concern has always
been and should continue to be for the originating order-i.e., the
unsolicited part of the order that is seeking liquidity-and not the
professional responders and providers of liquidity. The Exchange
believes that allowing smaller orders to participate on the other side
(i.e., contra-side) of QCC Orders not only provides the best price and
opportunity for a trade to occur in a tight and liquid market, but
ensures that the highest possible number of liquidity providers are
able to participate, and states that limiting participation only to
liquidity providers who are willing to participate on the trade for
1,000 contracts conversely could result in an inferior price by
shutting out some participants due to the large size and thereby
minimizing the opportunity for competition and price improvement.
In Amendment No. 1, the Exchange represents that it tracks and
monitors QCC Orders to determine which is the originating/agency side
of the order and which is the contra-side(s) of the order to ensure
that Members are complying with the minimum 1,000 contract size
limitation on the originating/agency side of the QCC Order. The
Exchange states that it checks to see if Members are aggregating
multiple orders to meet the 1,000 contract minimum on the originating/
agency side of the trade in violation of the requirements of the rule.
The rule requires that the originating/agency side of the trade consist
of one party who is submitting a QCC Order for at least 1,000
contracts. The Exchange represents that it enforces compliance with
this portion of the rule by checking to see if a Member breaks up the
originating/agency side of the order in a post trade allocation to
different clearing firms, allocating less than 1,000 contracts to a
party or multiple parties. For example, a Member enters a QCC Order
into the system for 1,500 contracts and receives an execution.
Subsequent to the execution, the Member allocates the originating/
agency side of the order to two different clearing firms on a post
trade allocation basis, thereby allocating 500 contracts to one
clearing firm and 1,000 contracts to another clearing firm. The
Exchange states that this type of transaction would not meet the
requirements of a QCC Order under the current rule.
With regard to order entry, the Exchange clarifies that a Member
must mark the originating/agency side as the first order in the system
and the contra-side(s) as the second. The Exchange states that it
monitors order entries to ensure that Members are properly entering QCC
Orders into the system.
IV. Summary of Comment Letters and ISE's Response to Comments
The Commission received three comment letters opposing the proposed
rule change.\14\ As described in more detail below, the commenters
primarily expressed concerns about QCC Orders generally, as opposed to
the rule modifications proposed by the Exchange.
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\14\ See supra note 5.
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In the NYSE Letter, the commenter does not raise new concerns, but
rather concurs with the issues expressed in a comment letter submitted
by the Chicago Board Options Exchange (``CBOE'') in response to a
separate filing by another exchange--SR-Phlx-2013-106-which proposed to
permit multiple contra-side parties on either side of a QCC Order and
eliminate the minimum size requirement, but which was subsequently
withdrawn. The commenter asserts that CBOE's comments are applicable to
the instant proposal.\15\ Specifically, this commenter echoes CBOE's
belief that QCC trades, by their nature, harm options markets by
enabling market participants to effect listed options transactions
without exposing their order to the market--hampering liquidity by
reduced transparency and eliminating the possibility of price
improvement.\16\ In
[[Page 19682]]
addition, the commenter concurs with CBOE's conclusion that an
expansion of the use of the QCC Order by reducing the minimum size
required to participate in a QCC trade would exacerbate the harm to the
options markets resulting from QCC trades.\17\
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\15\ See letter to Elizabeth M. Murphy, Secretary, Commission,
from Angelo Evangelou, Associate General Counsel, Chicago Board
Options Exchange, Incorporated, dated December 13, 2013 (``CBOE
Letter''). SR-Phlx-2013-106 was withdrawn on February 3, 2014. CBOE
did not submit a comment letter on this filing.
\16\ See NYSE Letter at 1; see also CBOE Letter at 2-3.
\17\ See NYSE Letter at 1; see also CBOE Letter at 3.
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Another commenter to the instant filing claims that market
participants use QCC Orders to disadvantage customers and avoid due
diligence obligations.\18\ In support of this contention, the commenter
notes that QCC Orders allow market participants to execute the stock
portion of a stock/option order outside the NBBO, resulting in inferior
net execution prices for customers.\19\ The commenter states that such
use of QCC Orders allows orders to be effected which do not need to
adhere to best-executions on a net cash basis to the detriment of
customers, and argues that requiring exposure of orders would curtail
this abuse.\20\
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\18\ See Story Letter at 1.
\19\ See Story Letter at 1-2.
\20\ See id.
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This commenter also argues that the fee structure in place for QCC
Orders creates a conflict of interest among market participants in that
a rebate is paid to executing brokers that initiate a QCC Order while a
fee is charged to the counter-parties.\21\ The commenter believes that
the incentive to obtain the rebate offered for QCC Orders can cause
brokers to ignore their responsibility to obtain the best price on a
trade and mitigate unnecessary fees whenever possible.\22\
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\21\ See Story Letter at 3.
\22\ See id.
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The third commenter requested that the Commission disapprove the
proposal, stating that the filing defies the general principles that
all orders be exposed to as many sources of liquidity as possible.\23\
The commenter believes that without exposure there is no incentive for
market makers to display liquidity, provide liquidity, or offer price
improvement, resulting in the general public failing to receive the
best possible price on any order.\24\
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\23\ See Cutler Letter at 1.
\24\ See id.
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In response to the comment letters, ISE states that it does not
believe that the commenters raise any issues related to removing the
contra-party size restriction for QCC Orders as proposed.\25\ Further,
ISE notes that the issues raised by the commenters were well vetted by
the Commission prior to the Original QCC Approval Order and therefore
does not believe that the commenters raise new issues relevant to the
current proposal.\26\
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\25\ See ISE Response at 1.
\26\ Id.
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V. Discussion and Commission Findings
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange.\27\
Specifically, the Commission finds that the proposed rule change is
consistent with Section 6(b)(5) of the Act,\28\ which requires, among
other things, that the rules of a national securities exchange be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to remove impediments
to and perfect the mechanism of a free and open market and a national
market system and, in general, to protect investors and the public
interest.
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\27\ In approving the proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. See 15 U.S.C.
\28\ 15 U.S.C. 78f(b)(5).
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In its original approval of the QCC Order for ISE, the Commission
noted the benefits of contingent trades to investors and the market as
a whole.\29\ Specifically, in providing for an exemption from certain
requirements of Regulation NMS for QCTs, the Commission recognized that
contingent trades can be ``useful trading tools for investors and other
market participants, particularly those who trade the securities of
issuers involved in mergers, different classes of shares of the same
issuer, convertible securities, and equity derivatives such as
options'' [italics added].\30\ In the Original QCC Approval Order, the
Commission also reiterated the finding from its Original QCT Exemption
that those transactions that meet the specified requirements of the QCT
exemption could be of benefit to the market as a whole and a
contribution to the efficient functioning of the securities markets and
the price discovery process.\31\
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\29\ See Original QCC Approval Order, supra note 8, at 11540-
11541.
\30\ See Securities Exchange Act Release No. 54389 (August 31,
2006, 71 FR 52829, 52830 (September 7, 2006) (``Original QCT
Exemption'').
\31\ See Original QCC Approval Order, supra note 8 at text
accompanying footnote 115.
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In analyzing ISE's original QCC Order, the Commission weighed the
benefits of QCTs, of which QCC Orders are a subset, against the
benefits provided by the general requirement for exposure of orders in
the options markets.\32\ In the Original QCC Approval Order, the
Commission stated that the QCC Order strikes an appropriate balance for
the options market in that it is narrowly drawn and establishes a
limited exception to the general principle of exposure and retains the
general principle of customer priority in the options markets because
QCC Orders are required to be: (1) Part of a QCT under Regulation NMS;
(2) for at least 1,000 contracts; (3) executed at a price at or between
the national best bid or offer; and (4) cancelled if there is a
Priority Customer Order on ISE's limit order book at the same
price.\33\ The Commission specifically noted that a QCC Order must not
only be part of a QCT by satisfying each of the six underlying
requirements of the NMS QCT Exemption, but must be for a minimum size
of 1,000 contracts, and that these requirements provide another limit
to its use by ensuring only transactions of significant size may avail
themselves of this order type.\34\ Given the requirements for QCC
Orders, the Commission also noted its belief that those customers
participating in QCC Orders would likely be sophisticated investors who
should understand that their order would not be exposed for potential
price improvement, and that these customers should be able to
themselves assess whether the net prices they are receiving for their
QCC Order are competitive.\35\ The Commission also specifically noted
that broker-dealers are subject to a duty of best execution for their
customers' orders, and that duty does not change for QCC Orders.\36\
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\32\ Id. at 11541.
\33\ Id.
\34\ Id.
\35\ Id.
\36\ Id.
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In considering ISE's proposal to eliminate the minimum size
requirement for the contra-side of QCC Orders, the Commission has again
weighed whether the benefits of this order type, as proposed to be
modified, to investors and the market outweigh the benefits provided by
the general requirement for exposure of orders in the options markets.
The Commission notes that ISE's proposal does not change the
requirements that a QCC Order must be: (1) Part of a QCT under
Regulation NMS; (2) executed at a price at or between the national best
bid or offer; and (3) cancelled if there is a Priority Customer Order
on ISE's limit order book. In addition, the changes to QCC Orders under
SR-ISE-2013-71\37\ permit multiple contra-side orders for QCC Orders,
so long as each such contra-side order is for at least 1,000 contracts.
In this filing, the only
[[Page 19683]]
requirement that ISE proposes to change is to eliminate the requirement
that contra-side orders of a QCC Order be for at least 1,000 contracts.
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\37\ See supra note 12.
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The Commission believes that this change to the minimum size
requirement for the contra-side(s) of QCC Orders is narrowly tailored
and, significantly, the Exchange's rule text clearly requires that the
originating side of a QCC Order must be comprised of a single order
(i.e., a single party) for at least 1,000 contracts. The Commission
believes that retention of the requirements that the original side be
comprised of a single order from a single party and that such single
order be for at least 1,000 contracts will continue to ensure that
sophisticated investors, who are aware that their orders will not be
exposed for price improvement, and who themselves should be able to
assess whether the net prices for their QCC Orders are competitive,
will initiate QCC Orders in an effort to effectuate a complex
transaction that complies with all the requirements of the QCC Order.
The proposed rule change will allow multiple contra-parties with
order sizes of less than 1,000 to aggregate their interest to pair
against the originating side of a QCC Order to facilitate the execution
of the QCC Order. The Commission believes that allowing smaller orders
from multiple parties to participate on the contra-side of QCC Orders
may provide a better opportunity for QCC Orders to be executed and,
potentially, at better prices. The Commission acknowledges that
limiting participation on the contra-side of a QCC Order only to
liquidity providers who are willing to participate on the trade for
1,000 contracts, could result in less interest in the trade than if
contra-side orders were not required to meet the 1,000 contract
minimum, potentially diminishing the opportunity for competition and
price improvement. The Commission believes that the proposed
modification to the definition of QCC Order is narrowly drawn in that
it does not impact the fundamental aspects of this order type, and
merely permits QCC Orders to include multiple contra-parties,
regardless of size on the contra-side, while preserving the 1,000
contract minimum on the originating side of a QCC Order. Accordingly,
the Commission finds the proposed rule consistent with the Act.
The issues raised in the comment letters do not specifically
address the changes proposed in the instant filing, and the Commission
agrees with ISE that the commenters on the proposed rule change do not
present any arguments that were not considered fully in Original QCC
Approving Order (i.e., QCC Orders harm the market by not requiring
exposure), or are outside the scope of this proposal (i.e., fee rebates
for initiating QCC Orders create a conflict of interest for
brokers).\38\
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\38\ In addition, the Commission again emphasizes, as it did in
the Original QCC Approval Order, that broker-dealers are subject to
a duty of best execution for their customers' orders, and that duty
does not change for QCC Orders. See supra note 36.
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The Commission notes that, given the differing requirements as
between the originating side and contra-side for QCC Orders, it is
essential that the Exchange be able to clearly identify and monitor--
throughout the life of a QCC Order, beginning at time of order entry on
the Exchange through the post-trade allocation process--each side of
the QCC Order and ensure that the requirements of the order type are
being satisfied including, importantly, those relating to the
originating side. The Commission believes this to be critical so that
the Exchange can ensure that market participants are not able to
circumvent the requirements of the QCC Order (as amended by this
proposed rule change), each of which the Commission continues to
believe are critical to ensuring that the QCC Order is narrowly
drawn.\39\ Further, the Commission notes that, in Amendment No. 1, the
Exchange has made certain representations regarding its enforcement and
surveillance of its Members' use of QCC Orders, including, for example,
not only at the time of order entry, but through the post-trade
allocation process as well.
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\39\ The Commission expects the Exchange to have the capability
to enable it to surveil that such requirements are being met. Though
the Exchange has stated its ability to do so in Amendment No. 1, if
the Exchange is not able to have such monitoring at any point in
time, the Commission would expect the Exchange to take other steps
to ensure that the QCC Order cannot be improperly used. For example,
if the Exchange were not able to identify and monitor which side of
a QCC Order is the originating order, the Commission would expect
that it would require that both sides of the QCC Order meet the more
stringent requirements of the originating side, i.e., that it be for
a single order for at least 1,000 contracts.
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For the foregoing reasons, the Commission believes that the
proposed rule change is consistent with the Act.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act
\40\ that the proposed rule change (SR-ISE-2013-72), as modified by
Amendment No.1, be, and it hereby is, approved.
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\40\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\41\
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\41\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-07892 Filed 4-8-14; 8:45 am]
BILLING CODE 8011-01-P