6124 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

1See infra notes 46–50 and accompanying text.

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Part 240 

[Release No. 34–49175; File No. S7–07–04] 

RIN 3235–AJ15 

Competitive Developments in the 

Options Markets

AGENCY: Securities and Exchange 

Commission (‘‘SEC’’ or ‘‘Commission’’).

ACTION: Concept release; request for 

comments. 

SUMMARY: This Concept Release 

discusses changes in the options 

markets that have occurred since the 

start of widespread multiple trading of 

options that have had the greatest 

impact on competition. It also seeks 

comment on whether the Commission 

should take any action to improve the 

efficiency of the options markets and 

mitigate the conflicts of interest that 

may be impeding price competition in 

those markets.

DATES: Comments should be received by 

April 9, 2004.

ADDRESSES: To help us process and 

review your comments more efficiently, 

comments should be sent by hard copy 

or e-mail, but not by both methods. 

Comments sent by hard copy should be 

submitted in triplicate to Jonathan G. 

Katz, Secretary, Securities and Exchange 

Commission, 450 Fifth Street NW., 

Washington, DC 20549–0609. 

Comments also may be submitted 

electronically at the following e-mail 

address: rule-comments@sec.gov. All 

comment letters should refer to File No. 

S7–07–04. This file number should be 

included in the subject line if e-mail is 

used. All comments received will be 

posted on the Commission’s Internet 

Web site (http://www.sec.gov) and made 

available for public inspection and 

copying in the Commission’s Public 

Reference Room, 450 Fifth Street NW., 

Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT:

Elizabeth King, Associate Director, at 

(202) 942–0140, Richard Strasser, 

Attorney Fellow, (202) 942–0737, 450 

Fifth Street NW., Washington, DC 

20549–1001. 

Table of Contents

I. Introduction 

II. Overview of Recent Changes 

A. Traditional Options Market Structure 

B. Start of Multiple Listing 

C. A New Options Exchange 

III. Impact of Enhanced Competition 

A. Narrower Spreads 

B. Marketplace Innovations 

1. Expansion of Auto-Ex Systems 

2. Enhanced Automation of Trading on 

Floor-Based Exchanges 

3. Displaying Size in Quotes 

4. Automated Systems that Enhance 

IntraMarket Quote Competition 

C. Payment for Order Flow, Specialist 

Guarantees, and Internalization 

1. Payment for Order Flow Arrangements 

2. Specialist Guarantees 

3. Internalization 

IV. Concerns with Payment for Order Flow, 

Specialist Guarantees, and 

Internalization 

A. Quote Competition 

B. Best Execution 

C. Conflicts between the Roles of Market 

and SRO

V. Regulatory Initiatives 

A. Exchange Act Rule 11Ac1–6 

B. Decimals 

C. Intermarket Linkage 

D. Applying the Quote Rule to Options 

E. Enforcement Settlement 

VI. Additional Steps that Could Be Taken to 

Address Concerns about Payment for 

Order Flow, Specialist Guarantees, and 

Internalization 

A. Should the Commission Take Action at 

this Point? 

B. Should the Commission Require Brokers 

to Rebate All or a Portion of Payments 

They Receive? 

C. Should the Commission Ban Payment 

for Order Flow, Specialist Guarantees, 

and Internalization? 

D. Should the Commission Ban Only 

Exchange-Sponsored Payment for Order 

Flow? 

1. Phlx Petition 

2. Susquehanna Request 

E. Should the Commission Establish 

Uniform Rules and Enforcement 

Standards Regarding Internalization and 

Specialist Guarantees? 

F. Should the Commission Apply Rule 

11Ac1–5 to Options? 

G. Would Penny Quotes in Options Reduce 

Payment for Order Flow? 

H. Should the Commission Apply the 

Limit Order Display Rule to Options? 

VII. Solicitation of Additional Comments

I. Introduction 

Competition among U.S. options 

exchanges dramatically expanded in the 

fall of 1999 when these markets began 

to compete by trading many of the same 

options products. This competition has 

had a number of benefits. Soon after this 

competition among the markets began, 

however, order entry firms started 

seeking opportunities to trade with their 

orders or be paid for their order flow 

from the competing markets. Since that 

time, payment for order flow and 

internalization of orders have become 

commonplace. 

While there has been a great deal of 

informal discussion about the ways in 

which payment for order flow and 

internalization impact the options 

markets and other market participants, 

the Commission has not yet formally 

requested public comment on these and 

other similar practices, such as 

specialist participation guarantees, and 

whether these practices raise concerns. 

This Concept Release discusses the 

changes in the options markets since the 

start of widespread multiple trading of 

options that have had the greatest 

impact on competition. It also seeks 

comment on whether the Commission 

should take any action to improve the 

efficiency of the options market and 

mitigate the conflicts of interest that 

may be impeding price competition in 

those markets. 

II. Overview of Recent Changes 

A. Traditional Options Market Structure 

Prior to the start of widespread 

multiple listing of equity options in 

1999, the options exchanges then in 

operation (the American Stock 

Exchange (‘‘Amex’’), Chicago Board 

Options Exchange (‘‘CBOE’’), Pacific 

Exchange (‘‘PCX’’) and Philadelphia 

Stock Exchange (‘‘Phlx’’), collectively, 

‘‘floor-based options exchanges’’) had 

priority rules that allocated trades 

among competing market participants 

on their floors. Some of these allocation 

methods were designed to enhance 

price competition, while others were 

designed to achieve other purposes, 

such as rewarding specialists or market 

makers for providing liquidity to the 

market. 

To facilitate price competition on 

these markets, orders sent to the floors 

of each of the exchanges generally were 

exposed to an auction before a specialist 

and other market participants, including 

market makers and floor brokers in the 

crowd. Generally, contracts were 

allocated to the market participants in 

the following order: (1) The first 

identifiable bid or offer at the best price 

and (2) all other market participants on 

parity with the best bid or offer. This 

allocation principle was designed to 

promote price competition by rewarding 

market participants willing to set the 

best price. 

Nevertheless, the options exchanges 

deviated from price-time priority to 

achieve other goals. For example, the 

exchanges developed specialist 

guarantees to reward specialists for 

committing capital on the exchange 

floor. Specialist guarantees give priority 

to a specialist over other market makers 

by allocating a certain percentage of 

each order to the specialist when that 

specialist’s quote is equal to the best 

price quoted on the exchange.1 In 

addition, the options exchanges 

provided limited opportunities for 

upstairs firms to trade with large 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6125

2See infra notes 51–53 and accompanying text. 

This release uses the term ‘‘upstairs firm’’ to mean 

a broker-dealer that is seeking to facilitate or trade 

with its own public customer’s options order on an 

exchange upon which the broker-dealer is a 

member. The broker-dealer may or may not be 

affiliated with the specialist in the option issue that 

is the subject of the customer order.

3This release uses the term ‘‘auto-quote’’ to refer 

to an electronic system specialists and other market 

makers use that automatically monitors and 

instantly updates quotations using a mathematical 

formula measuring certain characteristics of the 

options and underlying interest. This formula is 

based on a number of components that impact the 

value of the option, such as volatility, interest rate, 

and dividend. See, e.g., Phlx Rule 1080, 

Commentary .01(a)–(b).

4See e.g., Exchange Act Release No. 47959 (May 

30, 2003), 68 FR 34441, 34442 (June 9, 2003) 

(approving SR–CBOE–2002–05).

5See, e.g., Exchange Act Release No. 45677 

(March 29, 2002), 67 FR 16476 (April 5, 2002) 

(approving SR–CBOE–2002–07). Any member of the 

trading crowd who submits a manual quote that 

improves an exchange’s disseminated quote is 

considered to be a responsible broker or dealer 

under Rule 11Ac1–1(c) under the Act and it must 

be firm for the price of its quote up to its 

disseminated size. Rule 11Ac1–1(b) under the Act 

requires the exchange that receives the manual 

quote to disseminate it. Id.

6 Id. As discussed below, the floor-based options 

exchanges reached a settlement with the 

Commission resulting from an enforcement action 

that requires, among other things, that those 

exchanges amend their existing rules governing 

their automated quotation and execution systems to 

increase incentives to quote competitively. See 

infra note and accompanying text.

7 In August 1999, 32% of equity options were 

traded on more than one exchange. By September 

2000, that number had risen to 45%. Over the same 

period, the percentage of aggregate option volume 

traded on only one exchange fell from 60% to 15%. 

Exchange Act Release No. 43085 (July 28, 2000), 65 

FR 47918, 47919 (August 4, 2000) (proposing to 

extend Exchange Act Rule 11Ac1–1 to options). 

According to the Options Clearing Corporation, by 

September 2003, 98.3% of equity options traded on 

more than one exchange. For a discussion of the 

early development of multiple trading in the 

options markets see Exchange Act Release No. 

24613 (June 18, 1987), 52 FR 23849 (June 25, 1987) 

(proposing Exchange Act Rule 19c–5).

8See, e.g., Exchange Act Release No. 22026 (May 

8, 1985), 50 FR 20310 (May 15, 1985).

9See Exchange Act Release No. 26870 (May 26, 

1989), 54 FR 23963 (June 5, 1989).

10For a discussion of some of the factors that may 

have contributed to the multiple listing of actively 

traded options, see ‘‘Poachers take stock, then wait 

and watch for more options: CBOE’s trading of Dell 

has put even more pressure on U.S. exchanges to 

abandon their ‘gentlemen’s agreement,’ ’’ Financial 

Times p. 26 (August 26, 1999).

11The ISE trades 597 options issues. Trading in 

these issues across all options exchanges represents 

about 90% of options industry volume. See http:/

/www.iseoptions.com (Dec. 14, 2003).

12Under ISE’s rules, one Primary Market Maker 

(‘‘PMM’’) and at least two Competitive Market 

Makers (‘‘CMMs’’) are assigned to each options 

class traded on the exchange. ISE Rule 802(c). 

Among other obligations, a PMM must enter 

continuous, two-sided quotes in all of the options 

classes to which it is assigned. A CMM must 

participate in the opening and make markets and 

enter into any resulting transaction on a continuous 

basis in at least 60% of the options classes in the 

group of classes to which it is assigned. ISE Rule 

804. CMMs are able to stream their quotes on ISE 

electronically. By contrast, until recently, the floorbased options exchanges’ disseminated quotes 

represented only the auto-quote price of the 

specialist or specialist-equivalent. The other market 

makers could effect changes in that quote only 

through open outcry or through the manual entry 

of quotes. See, e.g., Exchange Act Release No. 47676 

(April 14, 2003), 68 FR 19865, 19866 (April 22, 

2003) (SR–CBOE–2002–05, proposing to establish 

CBOE’s hybrid trading system).

13Special Study: Payment for Order Flow and 

Internalization in the Options Markets, Office of 

Compliance Inspections and Examinations and 

Office of Economic Analysis (Dec. 2000) [‘‘SEC Staff 

Special Study’’].

customer orders where the crowd chose 

not to trade with them.2

In addition, the options exchanges 

developed automated execution (‘‘autoex’’) facilities to execute smaller orders 

quickly and efficiently at the prevailing 

bid or offer without first exposing those 

orders to an auction. These orders were 

automatically executed at the 

exchange’s disseminated price, which in 

almost all cases was the price generated 

by the specialist’s auto-quote.3 Under a 

traditional options market structure, the 

specialist is the only market maker on 

the exchange with the capability to 

auto-quote, and these quotes are 

considered the quotes of all the market 

makers in the crowd.4 Exchange rules 

generally permit a market maker to 

improve the price established by the 

specialist’s auto-quote by announcing 

the better price in the crowd. The 

specialist (or an exchange quote 

reporter) then manually reflects this 

better price in the exchange’s 

disseminated quote. This manual 

process is cumbersome, permitting 

market makers to improve the quote 

only in one series of an option at a 

time.5 In addition, until recently, there 

was little incentive to improve the quote 

generated by the specialist’s auto-quote 

because exchange rules allocating 

automatically executed orders did so 

regardless of whether a particular 

market maker improved the quote.6

B. Start of Multiple Listing 

From 1977 until August 1999, most 

actively traded options were listed on 

only one exchange.7 Moreover, unlike in 

equity securities, there is no over-thecounter market for standardized 

options. Consequently, firms had no 

choice as to where to send a customer’s 

order for such singly listed options. The 

Commission has long held the view that 

multiple listing of equity options, 

subject to the Commission’s oversight 

under the national market system, could 

spur competition among options 

markets to provide more efficient 

trading services resulting in lower 

transaction costs for investors.8 To 

promote multiple listing, the 

Commission adopted Exchange Act Rule 

19c–5 in 1989.9

Rule 19c–5 prohibits exchanges from 

having rules that limit their ability to 

list any stock options class because that 

options class is listed on another 

options exchange. Nevertheless, most 

options did not begin trading on 

multiple markets until August 1999.10

Today, virtually all actively traded 

equity options trade on multiple 

markets, a development that has 

enhanced competition among the 

options exchanges.

C. A New Options Exchange 

The launch of the International 

Securities Exchange (‘‘ISE’’) in May 

2000, the first new exchange in over two 

decades, further intensified 

competition.11 ISE introduced to the 

U.S. a market model for options in 

which multiple market makers on the 

exchange quote independently.12 ISE’s 

disseminated prices are the result of this 

intramarket competition.

Greater competition among options 

exchanges for order flow has manifested 

itself in many ways. Exchange 

transaction fees for customers have all 

but disappeared. Spreads are narrower. 

Markets have expanded and enhanced 

the services they offer and introduced 

innovations to improve their 

competitiveness. At the same time, 

inducements to order flow providers, 

including payment for order flow and 

internalization opportunities, have 

increased.

III. Impact of Enhanced Competition 

A. Narrower Spreads 

One of the most palpable results of 

enhanced competition in the options 

markets is the narrowing of spreads. 

Lower spreads can provide better prices 

for investors. In December 2000, the 

Commission staff issued the results of a 

preliminary study of one-week periods 

from August 1999 (a benchmark period 

prior to widespread multiple listing of 

actively traded options) and October 

2000 (a benchmark period during which 

the actively traded options in the study 

were listed on more than one exchange) 

to determine, among other things, how 

multiple listing impacted quote 

competition and spreads in the options 

markets.13 The staff found that average 

exchange-quoted spreads (i.e., 

intraexchange spreads, representing the 

bid and the offer of one exchange) for 

the most actively traded options (i.e., 

those under $20) decreased by 8% from 

the August 1999 period to the October 

2000 period. Exchange-quoted spreads 

indicate how aggressively the market 

participants on individual exchanges 

6126 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

14The NBBO is the interexchange best bid or 

offer, where each side of the best bid and offer, 

regardless of the quoting exchange, is used. 

Although an NBBO was not calculated for the 

options markets at the time the study was 

conducted, the SEC staff calculated one for 

purposes of the study.

15The SEC Staff Special Study concluded that, in 

addition to multiple listing, the drop in the 

consolidated NBBO spread also could have been 

attributed, at least in part, to the entrance of ISE 

into the market at that time. See SEC Staff Special 

Study, supra note 13 at text accompanying notes 

72–73.

16The effective spread is twice the absolute 

difference between the trade price and the midpoint 

of the bid-ask spread at the time the trade report 

was received by the Options Price Reporting 

Authority. The lower the effective spread, the lower 

the cost to the investor.

17The realized spread is a measure of trading 

costs, taking into account the informational impact 

of the trade. It compares execution prices to the bid/

offer mid-point five minutes after the execution 

occurs, which provides a hypothetical measure of 

a trade’s profitability to the executing broker. 

Effective spreads and realized spreads reflect the 

direct costs to investors of trading on a given 

options market.

18See, e.g., Battalio, Robert, Brian Hatch, and 

Robert Jennings, ‘‘Toward a National Market System 

for U.S. Exchange-Listed Equity Options,’’ Journal 

of Finance, forthcoming (covering June 2000 to 

January 2002 and indicating that bid-ask spreads 

have declined since multiple listing of most active 

options) and De Fontnouvelle, Patrick, Raymond 

P.H. Fishe, and Jeffrey H. Harris, ‘‘The Behavior of 

Bid-Ask Spreads and Volume in Options Markets 

During the Competition for Listings in 1999,’’

Journal of Finance, Vol. 58, No. 6 pp. 2437–2463 

(2003) (indicating that spreads became significantly 

narrower around August 1999 when a large number 

of options moved from single to multiple listing). 

The results of these studies are consistent with 

other research that studied earlier periods. See, e.g., 

Mayhew, Stewart ‘‘Competition, Market Structure, 

and Bid-Ask Spreads in Stock Option Markets,’’

Journal of Finance v.57 n.2 (April 2002) pp. 931–

958 (examining CBOE options from 1986 to 1997 

and indicating that options listed on multiple 

exchanges had narrower spreads than those listed 

on a single exchange) and ‘‘The Effect of Multiple 

Trading on the Market for OTC Options,’’ SEC 

(1986).

19 During the 1980s, options exchanges permitted 

orders in sizes of between five and ten options 

contracts to be executed through their auto-ex 

systems. See, e.g., Exchange Act Release Nos. 21695 

(Jan. 28, 1985), 50 FR 4823 (Feb. 1, 1985) (File No. 

SR–CBOE–84–30) (permitting automated executions 

of up to five contracts); 22015 (May 6, 1985), 50 FR 

19832 (May 10, 1985) (File No. SR–CBOE–85–14) 

(permitting automated executions of up to ten 

contracts); and 27599 (Jan. 9, 1990), 55 FR 1751 

(Jan. 18, 1990) (File No. SR–Phlx–89–03) 

(permitting automated executions of up to ten 

contracts). PCX allowed automated executions of up 

to ten contacts in 1993. See Exchange Act Release 

No. 32703 (July 30, 1993), 58 FR 42117 (August 6, 

1993) (File No. SR–PSE–92–37). 

Over the next decade, the maximum number of 

options contracts per order permitted for automated 

execution steadily increased from ten contracts to 

fifty contracts. See, e.g., Exchange Act Release Nos. 

24899 (Sept. 10, 1987), 52 FR 35012 (Sept. 16, 1987) 

(File No. SR–Amex–87–21); 28411 (Sept. 6, 1990), 

55 FR 37784 (Sept. 13, 1990) (File Nos. SR–CBOE–

89–27 and SR–CBOE–89–29); 29837 (Oct. 18, 1991), 

56 FR 55146 (Oct. 24, 1991) (File No. SR–Phlx–91–

33); and 34946 (Nov. 7, 1994), 59 FR 59265 (Nov. 

16, 1994) (File No. SR–PSE–94–18); 32906 (Sept. 

15, 1993), 58 FR 49345 (Sept. 22, 1993) (File No. 

SR–Phlx–92–38); 36601 (Dec. 18, 1995), 60 FR 

66817 (Dec. 26, 1995) (File No. SR–Phlx–95–39); 

41821 (Sept. 1, 1999), 64 FR 50313 (Sept. 16, 1999) 

(File No. SR–CBOE–99–17); 41823 (Sept. 1, 1999), 

64 FR 49265 (Sept. 10, 1999) (File No. SR–PCX–99–

04); and 42094 (Nov. 3, 1999), 64 FR 61675 (Nov. 

12, 1999) (File No. SR–Amex–99–43).

20See Exchange Act Release Nos. 43516 (Nov. 3, 

2000), 65 FR 69079 (Nov. 15, 2000) (File No. SR–

Amex–99–45); 43517 (Nov. 3, 2000), 65 FR 69082 

(Nov. 15, 2000) (File No. SR–CBOE–99–51); 43515 

(Nov. 3, 2000), 65 FR 69114 (Nov. 15, 2000) (File 

No. SR–Phlx–99–32); and 43518 (Nov. 3, 2000), 65 

FR 69111 (Nov. 15, 2000) (File No. SR–PCX–00–32).

21See Exchange Act Release Nos. 43887 (Jan. 25, 

2001), 66 FR 8831 (Feb. 2, 2001) (File Nos. SR–

Amex–00–57 and SR–PCX–00–18); 44008 (Feb. 27, 

2001), 66 FR 13599 (March 6, 2001) (File No. SR–

CBOE–01–03); 44054 (March 8, 2001), 66 FR 15314 

(March 16, 2001) (File No. SR–Phlx–2001–31) 

(permitting automated executions of up to 100 

contracts in QQQ options); and 44404 (June 11, 

2001), 66 FR 32857 (June 18, 2001) (File No. SR–

Phlx–2001–51) (permitting automated executions of 

up to 100 contracts in all options).

22See Exchange Act Release Nos. 45628 (March 

22, 2002), 67 FR 15262 (March 29, 2002) (File No. 

SR–Amex–2001–94); 45641 (March 25, 2002), 67 FR 

15445 (April 1, 2002) (File No. SR–PCX–2001–48); 

45629 (March 22, 2002), 67 FR 15271 (March 29, 

2002) (File No. SR–Phlx–2001–89) (permitting 

automated executions of up to 250 contracts in 

QQQ options); and 45893 (May 8, 2002), 67 FR 

34746 (May 15, 2002) (File No. 2002–25) 

(permitting automated executions of up to 250 

contracts in all options).

23See Exchange Act Release No. 47673 (April 14, 

2003), 68 FR 19242 (April 18, 2003) (File No. SR–

Amex–2003–08). Amex floor officials have the 

discretion to raise the auto-ex limit to 500 contracts 

on a case-by-case basis.

are setting their quotes. Quoting across 

exchanges over this period showed a 

much more dramatic change. The tradeweighted consolidated national best bid 

and offer (‘‘NBBO’’)14 spreads fell from 

$0.29 in August 1999 to $0.18 in 

October 2000, a decline of nearly 

38%.15

The actual transaction costs that 

investors paid for their options 

executions (measured by effective 

spreads) also declined from the August 

1999 period to the October 2000 

period.16 The average effective spread 

for options priced below $20 was $0.21 

in August 1999 and $0.17 in October 

2000, a decline of approximately 19%. 

The most dramatic decline, however, 

was witnessed in smaller orders 

(typically orders of 50 or fewer 

contracts). For those orders, which are 

eligible for automatic execution, the 

average effective spread fell from $0.26 

in August 1999 to $0.17 in October 

2000, a drop of nearly 35%.

Average realized spreads (another 

measure of trading costs) for options 

priced below $20 were $0.18 in August 

1999 and $0.17 in October 2000.17

Average realized spreads for larger 

orders (i.e., those above 50 contracts and 

ineligible for automatic execution at that 

time) actually increased from $0.10 in 

August 1999 to $0.16 in October 2000 (a 

60% increase). This increase partially 

offset a fall in the average realized 

spread for smaller orders in these 

options, which declined from $0.23 in 

August 1999 to $0.16 in October 2000, 

a drop of approximately 30%.

The findings of academic economic 

studies that have examined the 

substantial increase in multiple listing 

of active options since late 1999 are 

consistent with the Commission staff’s 

findings.18

B. Marketplace Innovations 

In addition to narrowing spreads, the 

expansion of multiple trading has led 

the options markets to implement 

market structure innovations designed 

to attract more order flow by enhancing 

the efficiency, transparency, and 

liquidity of their markets. Such 

innovations include increasing the 

automated processing of orders routed 

to the floor-based options exchanges, 

expanding access to exchanges’

automated execution systems to include 

broker-dealer orders as well as customer 

orders, and displaying the size of 

trading interest in quotations. Finally, 

exchanges have implemented electronic 

systems that enhance intramarket 

competition by permitting market 

makers independently to auto-quote. 

1. Expansion of Auto-Ex Systems 

In response to evolving market 

structures, technological advances, and 

enhanced competition among the 

markets, options exchanges have made 

changes to their auto-ex systems. 

Initially, auto-ex systems were designed 

to provide instantaneous executions for 

small public customer orders. In 

response to competitive pressures and a 

growing demand for quicker and more 

efficient executions, the options 

exchanges began increasing the 

maximum number of contracts eligible 

for execution through their auto-ex 

systems.19 After the start of multiple 

listing, the use of auto-ex systems has 

expanded significantly.

In 2000, all of the floor-based options 

exchanges simultaneously increased the 

maximum number of options contracts 

in an order eligible for automated 

execution from fifty to seventy-five 

contracts 20 and quickly increased the 

size again to 100 contracts.21 In 2001, 

three of the options exchanges—Amex, 

Phlx, and PCX—increased their 

maximum guaranteed order size for 

automated execution to 250 contracts.22

In 2003, Amex increased its maximum 

guaranteed order size for automated 

executions to 500 contracts.23

The competitive responses with 

respect to one of the most widely traded 

exchange-traded funds, QQQ, which 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6127

24See Exchange Act Release No. 45676 (March 

29, 2002), 67 FR 16478 (April 5, 2002) (order 

approving File No. SR–CBOE–2001–70).

25See Exchange Act Release Nos. 45756 (April 15, 

2002), 67 FR 19603 (April 22, 2002) (notice of filing 

and immediate effectiveness of File No. SR–Amex–

2002–29).

26See Exchange Act Release No. 45828 (April 25, 

2002), 67 FR 22140 (May 2, 2002) (File No. SR–

Amex–2002–30).

27See Exchange Act Release No. 46531 (Sept. 23, 

2002), 67 FR 61370 (Sept. 30, 2002) (File No. SR–

Phlx–2002–47).

28See Exchange Act Release No. 47667 (April 10, 

2003), 68 FR 19244 (April 18, 2003) (File No. SR–

PCX–2003–14).

29See Exchange Act Release Nos. 45032 (Nov. 6, 

2001), 66 FR 57145 (Nov. 14, 2001) (File No. SR–

PCX–00–05); 46517 (Sept. 20, 2002), 67 FR 61182 

(Sept. 27, 2002) (File No. SR–PCX–2002–50); 46479 

(Sept. 10, 2002), 67 FR 58654 (Sept. 17, 2002) (File 

No. SR–Amex–2002–57); 45758 (April 15, 2002), 67 

FR 19610 (April 22, 2002) (File No. Phlx–2001–40); 

46660 (Oct. 15, 2002), 67 FR 64951 (Oct. 22, 2002) 

(File No. SR–Phlx–2002–50); 45967 (May 20, 2002), 

67 FR 37888 (May 30, 2002) (File No. SR–CBOE–

2002–22); 46113 (June 25, 2002), 67 FR 44486 (July 

2, 2002) (File No. SR–CBOE–2002–35); and 46598 

(Oct. 3, 2002), 67 FR 63478 (Oct. 11, 2002) (File No. 

SR–CBOE–2002–56).

30Exchange Act Release Nos. 48472 (Sept. 10, 

2003), 68 FR 54513 (Sept. 13, 2003) (permits 

automated execution on Phlx of eligible inbound 

customer and off-floor broker-dealer limit orders 

against booked customer limit orders at the 

exchange’s disseminated quote); 45244 (Jan. 7, 

2002), 67 FR 1526 (Jan. 11, 2002) (allows certain 

orders entered through CBOE’s order routing system 

to trade automatically against the book); and 42652 

(April 7, 2000), 65 FR 20235 (April 14, 2000) 

(incoming market and marketable limit orders 

bypass Amex’s auto-ex system and match against 

orders in the book).

31See Exchange Act Release Nos. 44462 (June 21, 

2001), 66 FR 34495 (June 28, 2001) (approving 

CBOE proposal to allow orders on the book to be 

executed automatically where a quote generated by 

the exchange’s auto-quote system is equal to or 

crosses the exchange’s best bid or offer as 

established by a booked order); and 44468 (June 22, 

2001), 66 FR 34505 (June 28, 2001) (approving PCX 

pilot program to allow automated execution of 

marketable limit orders against market makers 

when the limit orders are crossed or locked by 

PCX’s auto-quote system). See also File No. SR–

Phlx–2003–30 (Phlx proposal to execute 

automatically limit orders on the book when the 

exchange’s auto-quote (or a specialist’s quote) 

crosses or locks the exchange’s best market as set 

by an order in the book).

32Exchange Act Release No. 45974 (May 22, 

2002), 67 FR 37886 (May 30, 2002).

33See Exchange Act Release Nos. 44145 (April 2, 

2001), 66 FR 18662 (April 10, 2001) and 44383 

(June 2, 2001), 66 FR 30959 (June 8, 2001); and 

CBOE Regulatory Circular RG 01–50 (April 17, 

2001).

34See ISE Exchange Approval, infra note 52, text 

accompanying nn. 93–94.

35The Commission’s Office of Economic Analysis 

studied ten of the most actively traded options 

issues (AOL, Citigroup, Cisco, Dell, IBM, Microsoft, 

Intel Wrap, Pfizer, Peoplesoft, and QQQ Wrap) for 

the period of June 2–6, 2003 (prior to the 

implementation of CBOE’s hybrid trading system, 

discussed below) and found that ISE was at the best 

bid and at the best offer in these options 

significantly more frequently than any other options 

exchange. The study also found that ISE was alone 

at the best bid and offer significantly more 

frequently than any other exchange. ISE was at the 

inside bid 87% of the time compared to 56% of the 

time for CBOE, the next closest competitor. ISE was 

at the inside ask 83% of the time (compared with 

61% for CBOE, the next most frequent). ISE was 

alone at the inside bid 12% and alone at the inside 

ask 11% of the time (compared to CBOE’s 3% and 

5%, CBOE was the second most frequent in each).

36See, e.g., ‘‘CBOE Bets Streaming Quotes Will 

Cool ISE—The Chicago Board Options Exchange is 

launching a hybrid-trading system with streaming 

market-maker quotes to counter its all-electronic 

rival,’’ Wall Street & Technology p. 41 (July 1, 

2003). As discussed in Section V. E. infra, the 

enforcement settlement required the floor-based 

options exchanges, among other things, to amend 

their existing rules governing their automated 

quotation and execution systems to increase 

incentives to quote competitively.

tracks the Nasdaq 100 Index, illustrate 

the fiercely competitive nature of the 

options markets since the start of 

multiple listing. In 2002, CBOE began 

allowing automated executions of up to 

500 contracts in QQQ options.24 Amex 

immediately matched the CBOE’s 

proposal.25 ISE soon announced that its 

Primary Market Maker in the QQQ 

options would guarantee a size of up to 

2,000 contracts in the two near-term 

expiration months and up to 1,000 

contracts for all other expiration months 

for customer orders in QQQ options. 

Amex soon matched ISE’s move.26 In 

late 2002, Phlx matched ISE’s and 

Amex’s maximum guaranteed 

automated execution order size for QQQ 

options.27 In early 2003, PCX matched 

the other exchanges.28

In addition to increasing the size of 

public customer orders eligible for 

automated execution, in 2001, the 

options exchanges began permitting 

non-market maker broker-dealer orders 

to be executed through their respective 

auto-ex systems.29

2. Enhanced Automation of Trading on 

Floor-Based Exchanges 

The floor-based options exchanges 

have also increased the automated 

handling of orders on their facilities. For 

example, Phlx, CBOE, and Amex 

enhanced the integration of their 

automated execution systems with their 

order books to enable incoming orders 

to trade automatically with booked 

orders that establish the prevailing 

market.30 Similarly, several exchanges 

are automating the execution of orders 

on the book that lock or cross a quote 

generated by the exchange’s auto-quote 

systems.31 In addition, Amex automated 

the allocation of contracts between 

specialist and registered options traders 

under certain circumstances where the 

specialist would otherwise manually 

allocate such contracts.32

3. Displaying Size in Quotes 

Displaying information about the size 

of options quotes is another recent 

enhancement in the options markets. 

Since its inception in May 2000, the ISE 

displayed quotations accompanied by 

size within its market. At that time, the 

Options Price Reporting Authority 

(‘‘OPRA’’) did not collect from the 

options exchanges and disseminate to 

quotation vendors the sizes associated 

with options quotations. In addition, the 

floor-based options exchanges did not 

independently display the sizes of their 

market participants’ quotations. 

In response to the increased 

transparency offered on ISE’s electronic 

system, the floor-based exchanges began 

to implement technology to disseminate 

quotations with size. In addition, OPRA 

enhanced its systems to collect and 

disseminate quotations with size from 

the options exchanges. In 2001, each of 

the options exchanges began 

disseminating the size associated with 

their quotations through OPRA.33

4. Automated Systems That Enhance 

IntraMarket Quote Competition

ISE’s electronic structure enables it to 

collect and disseminate competitive 

quotes from multiple market makers. 

Because ISE’s market makers only trade 

with incoming orders when their quotes 

represent the best price,34 they have a 

strong incentive to quote aggressively. 

As a result, ISE’s disseminated prices 

represent the best quote of any market 

maker or priced order in the ISE order 

book and frequently set or match the 

best bid or offer in the market.35

Unlike the ISE, quotes on the floorbased options exchanges historically 

represented the auto-quotes of the 

specialists. These quotes, however, are 

considered the quotes of all market 

makers on the exchange. When orders 

are routed to a floor-based options 

exchange for automated execution, they 

generally trade at the auto-quoted price. 

Such orders are allocated to market 

makers in the crowd on a ‘‘wheel,’’

where they each take portions of an 

order in turn. Thus, market makers do 

not have an incentive, or even a 

practical ability, to improve the 

disseminated quote. 

ISE soon began to capture market 

share from the other options exchanges. 

In response to competition from ISE and 

to comply with the terms of a settlement 

agreement the floor-based options 

exchanges reached with the 

Commission, the floor-based exchanges 

introduced new technology to their 

trading platforms to enhance the speed 

and efficiency of executions on those 

markets.36 One of the more recent 

innovations is CBOE’s hybrid trading 

platform, which it began rolling out in 

2003. This new trading platform 

combines features of the open outcry 

6128 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

37Exchange Act Release No. 47959 (May 30, 

2003), 68 FR 34441 (June 9, 2003). 38For options that are not yet trading on the 

hybrid platform, CBOE’s disseminated quote 

represents, for the most part, only the automatically 

generated quotations of the DPM. Market makers are 

able to impact the CBOE quote only in open outcry 

or by inputting quotes manually. As a result, there 

is virtually no intraexchange quote competition in 

CBOE options that are not trading on the hybrid 

platform.

39Because the 22 options classes were phased in 

over multiple days between June 12 and July 11, 

2003, to compare spreads consistently it was 

necessary to assign event dates from ‘‘20 to 20 to 

each of the classes. An event date of ‘‘20 was the 

date 20 trading days before an option was phased 

into the hybrid platform. An event date of 0 was 

the date it was phased in, and an event date of 20 

was the date 20 trading days after a class was 

phased in.

40See, e.g., Exchange Act Release No. 47838 (May 

13, 2003), 68 FR 27129 (May 19, 2003) (order 

approving PCX’s hybrid trading platform for 

options). See also SR–Phlx-2003–59 (proposal to 

establish a new Phlx electronic trading platform 

that would permit exchange members to submit 

streaming electronic option quotations via an 

electronic interface with Phlx’s Automated Options 

Market System); and SR–Amex-2003–89 (proposing 

to establish a new trading system that would permit 

registered options traders to auto-quote 

independent of the specialist’s quote).

41 In its December 2000 study, the SEC staff 

examined the rise of payment for order flow 

arrangements in the options markets and found that 

the percentage of retail customer options orders that 

were paid for under a payment for order flow 

arrangement soared from August 1999, when 

virtually no orders were subject to such 

arrangements, to August 2000, when nearly 78% of 

such orders were. See SEC Staff Special Study, 

supra note 13. The staff found that cash payments 

were the most common form of payment for order 

flow in the options markets, although other 

inducements also were noted. For instance, some 

firms routed customer options orders to affiliated 

specialists. Firms that route order flow to an 

affiliated specialist are able to benefit through 

increased profits generated by that specialist, which 

does not have to pay cash for its affiliates’ order 

flow. Other firms have entered into reciprocal order 

flow arrangements, under which each agrees to 

route customer order flow to the other.

42The Commission has defined payment for order 

flow broadly as ‘‘any monetary payment, service, 

property, or other benefit that results in 

remuneration, compensation, or consideration to a 

broker or dealer from any broker or dealer, national 

securities exchange, registered securities 

association, or exchange member in return for the 

routing of customer orders by such broker or dealer 

to any broker or dealer, national securities 

exchange, registered securities association, or 

exchange member for execution, including but not 

limited to: research, clearance, custody, products or 

services; reciprocal agreements for the provision of 

order flow; adjustment of a broker or dealer’s 

unfavorable trading errors; offers to participate as 

underwriter in public offerings; stock loans or 

shared interest accrued thereon; discounts, rebates, 

or any other reductions of or credits against any fee 

to, or expense or other financial obligation of, the 

broker or dealer routing a customer order that 

exceeds that fee, expense or financial obligation.’’

17 CFR 240.10b–10(d)(9). In the Commission staff’s 

December 2000 study the staff concluded that while 

payment for order flow clearly impacted brokerdealers’ order routing decisions, such arrangements 

had not, at that point, had a material adverse impact 

on effective spreads. The staff concluded that 

further monitoring of the arrangements was 

warranted. See SEC Staff Special Study, supra note 

13.

market with an electronic, competing 

dealer model.37

As is the case with ISE’s model, 

CBOE’s hybrid trading platform allows 

market makers and designated primary 

market makers (‘‘DPM’s) (CBOE’s 

specialist equivalent) to submit 

electronically quotes that represent their 

own trading interest. In addition, floor 

brokers in the crowd may enter orders 

on behalf of their customers. The best 

bid and offer among submitted market 

maker quotes and customer orders is 

disseminated as CBOE’s best bid or 

offer. As such, the hybrid trading 

platform greatly expands the potential 

sources of intraexchange quote 

competition on CBOE.38

Preliminary research on the first 

group of securities phased into CBOE’s 

hybrid platform shows a dramatic 

narrowing of quoted and effective 

spreads in those securities on CBOE. 

The Commission’s Office of Economic 

Analysis examined average quoted and 

effective spreads of the first 22 options 

classes phased into CBOE’s hybrid 

trading platform and found that average 

quoted spreads decreased from $0.2422 

over the 20 trading days before each of 

the options was phased into the system, 

to $0.1929 in the 20 trading days after 

the options were phased in, a decrease 

of over 20%.39 The average effective 

spread for these securities on CBOE 

decreased from $0.1170 to $0.0974, a 

decline of nearly 17%. Two control 

samples were used to ensure that these 

observed changes were not driven by 

other, coincidental changes in market 

conditions’quotes on the same options 

on the other exchanges, and quotes on 

other CBOE options that did not switch 

to the hybrid platform. No similar 

decrease in quoted and effective spreads 

was observed in the control sample.

Other registered options exchanges 

have developed their own innovative 

technology platforms. For example, in 

May 2003, the Commission approved 

PCX’s new hybrid trading platform 

which will accommodate independent 

quotations from three types of market 

makers.40 As they do today, Lead 

Market Makers (‘‘LMMs’’) would 

continue to provide two-sided markets 

throughout the trading day, while 

conducting their trading activities on 

the floor of the exchange. Remote 

Market Makers would be permitted to 

enter quotes and effect trades from offsite locations and to select their 

appointed issues. Floor Market Makers, 

which are registered market makers 

with basic obligations on the PCX 

options floor, would continue to trade 

as they do today and would supply 

independently generated quotes with 

size. Members could choose not to 

generate their own quote independently 

by acting as Supplemental Market 

Makers, which would add liquidity at 

the same price that is then being 

disseminated by the LMM. PCX began 

phasing in the new platform on October 

6, 2003. Like the CBOE hybrid system, 

PCX’s system should enhance 

intraexchange quote competition.

C. Payment for Order Flow, Specialist 

Guarantees, and Internalization 

While encouraging innovations by 

options exchanges, multiple listing also 

resulted in competition among markets 

in the form of payment for order flow, 

enhanced specialist participation rights, 

and internalization. Unlike the forms of 

competition described above, which 

clearly benefit customers, these 

arrangements principally benefit 

intermediaries in the first instance, 

which may or may not pass on those 

benefits to their customers. The broad 

proliferation of these arrangements in 

the options markets followed 

widespread multiple listing of the most 

active options in 1999.41

When most options were traded on 

only one market, order entry firms had 

no choice where they routed their 

customers’ orders for execution. As the 

number of trading venues for those 

options increased, however, order entry 

firms could choose between these 

venues in executing customers’ orders. 

Indeed, where the same option trades on 

multiple venues, a broker-dealer’s best 

execution obligation requires regular 

and rigorous review of execution 

quality. As a result, options markets and 

the market participants that trade there 

have sought to make their markets more 

attractive to order entry firms whose 

order flow they are attempting to attract. 

As discussed above, market participants 

have adapted to greater competition by 

tightening spreads and the exchanges 

themselves have done so by enhancing 

services. 

At the same time, the specialists and 

market makers on the options markets 

have begun competing for order flow by 

offering cash or non-cash inducements, 

known as payment for order flow, to 

firms to send their orders to a particular 

exchange.42 Another inducement 

exchanges use to attract order flow is 

permitting firms to trade with—or 

internalize—their own customers’

orders. Both practices are a way to share 

the profit a dealer makes on a trade with 

the intermediary representing a 

customer order.

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6129

43Exchange Act Release Nos. 48053 (June 17, 

2003), 68 FR 37880 (June 25, 2003) (SR–Amex2003–50); 47948 (May 30, 2003), 68 FR 33749 (June 

5, 2003) (SR–CBOE–2003–19); 43833 (Jan. 10, 

2001), 66 FR 7822 (Jan. 25, 2001) (SR–ISE–00–10); 

43290 (Sept. 13, 2000), 65 FR 57213 (Sept. 21, 2000) 

(SR–PCX–00–30); and 47090 (Dec. 23, 2002), 68 FR 

141 (Jan. 2, 2003) (SR–Phlx-2002–75).

44See Exchange Act Section 19(b)(3)(A)(ii) (15 

U.S.C. 78s((b)(3)(A)(ii)) and Rule 19b–4(f)(2) (17 

CFR 240. 19b–4(f)(2)). Within 60 days of filing of 

a proposal filed under Exchange Act Section 

19(b)(3)(A), the Commission may summarily 

abrogate the proposal and require that the proposal 

be refiled (if at all) under Section 19(b)(1) of the 

Act, in which case the Commission must approve 

it prior to it becoming effective. See Exchange Act 

Section 19(b)(3)(C), 15 U.S.C. 78s(b)(3)(C).

45See Exchange Act Release No. 43290 (Sept. 13, 

2000), 65 FR 57213, 57214–215 (Sept. 21, 2000) 

(notice of filing and immediate effectiveness of SR–

PCX–00–30); see also Exchange Act Release Nos. 

43112 (August 3, 2000), 65 FR 49040 (August 10, 

2000) (notice of filing and immediate effectiveness 

of SR–CBOE–00–28) and 43833, 66 FR at 7825 

(approving SR–ISE–00–10, imposing such fees is a 

legitimate business decision of the exchange).

46The term specialist is used in this release to 

include, in addition to specialists, DPMs, LMMs 

and PMMs.

47Each exchange has rules of priority, parity, and 

precedence that govern the order in which bids and 

offers participate in a transaction. For a discussion 

of exchanges’ execution priority rules see Exchange 

Act Release No. 43100 (July 31, 2000), 65 FR 48778, 

48785 (August 9, 2000) (File No. SR-Phlx–00–01, 

proposing to amend Phlx’s enhanced specialist 

participation provisions) [‘‘Notice of Phlx 80/20 

Proposal’’].

48The 80% provision would have applied to 

orders for the top 100 options based on volume 

allocated to a Phlx specialist after January 1, 1997 

(i.e., new allocations). Although the proposal had a 

number of provisions other than the 80% allocation 

provision, the Commission expressed particular 

concern with that provision. Id., 65 FR at 48784.

49 Id.

50 Id. at 48789.

51Of course, if no other market participant on the 

exchange is willing to trade with a particular order, 

the upstairs firm may internalize the entire order.

1. Payment for Order Flow 

Arrangements 

Under a typical payment for order 

flow arrangement, a specialist offers an 

order entry firm cash or other economic 

inducement to route its customer orders 

to that specialist’s exchange because the 

specialist knows it will be able to trade 

with a portion of all incoming orders, 

including those from firms with which 

it has payment for order flow 

arrangements. The more dominant the 

specialist is on a particular exchange 

(i.e., the fewer market makers with 

which it must compete for order flow), 

the more order flow it will trade with 

and the more it will be able to pay for 

order flow. Consequently, specialists 

benefit from exchange rules that 

guarantee the specialist the ability to 

trade with a certain percentage of the 

order flow for which they pay. Such 

‘‘specialist guarantees’’ are discussed 

further below. 

A specialist on an exchange where its 

role is less dominant (i.e., where market 

makers in the crowd successfully 

compete with the specialist to trade 

with incoming orders), cannot, on its 

own, pay as much for order flow. For 

this reason, to compete, exchanges 

where there is substantial competition 

among market makers were the first to 

impose fees upon their members to fund 

payment for order flow collectively. 

Such exchange fees were designed to 

ensure that market makers that may 

trade with customers on the exchange 

contribute to the cost of attracting that 

order flow. Currently, all of the options 

exchanges have such ‘‘exchangesponsored payment for order flow 

programs’’ in place.43

Section 19 of the Act and Rule 19b4 adopted under the Act permit such 

payment for order flow arrangements to 

become effective upon filing and 

therefore do not require prior 

Commission approval because the 

arrangements impose fees that apply 

only to members of the exchange.44 In 

soliciting public comment on one such 

proposal, the Commission noted that 

while it is concerned about payment for 

order flow generally, the Act provides a 

self-regulatory organization (‘‘SRO’’) 

wide latitude in imposing fees on its 

members.45

2. Specialist Guarantees 

All five options exchanges currently 

have rules that guarantee a specialist a 

proportion of each order when its quote 

is equal to the best price on the 

exchange.46 These so-called ‘‘specialist 

guarantees’’ reward market making 

firms willing to perform the obligations 

of a specialist by ensuring that they will 

be able to interact as principal with a 

certain percentage of incoming orders. 

Specialist guarantees are special 

allocation provisions that differ from the 

general rules of the exchanges that 

assign executions based on priority, 

parity, and precedence.47 Specialist 

guarantees are intended to attract and 

retain well-capitalized firms that are 

responsible under exchange rules for 

assuring fair and orderly markets and 

fulfilling other responsibilities that 

enhance the exchange.

The Commission has closely 

scrutinized exchange rule proposals to 

adopt or amend a specialist guarantee 

where the percentage of specialist 

participation would rise to a level that 

could have a material adverse impact on 

quote competition within a particular 

exchange. For instance, in 2000 Phlx 

filed a proposal with the Commission to 

raise its specialist participation to 80% 

for certain options orders.48 This 

specialist guarantee may have helped 

Phlx compete with other exchanges 

because its specialists, all things being 

equal, may have been able to pay more 

to attract order flow than other 

exchanges’ specialists that received a 

lesser guarantee.

The Commission was concerned, 

however, that the Phlx proposal could 

have significantly discouraged price 

competition on that market by ‘‘locking 

up’’ such a large proportion of each 

order that it would have hindered 

market makers in the crowd from 

competing with the specialist. The 

Commission believed that, over the 

long-term, the decrease in intramarket 

competition could have widened 

spreads and diminished the quality of 

prices available to investors.49

Moreover, the Commission was 

concerned that, if it approved the Phlx 

proposal, other exchanges could have 

proposed similar specialist guarantees 

to remain competitive,50 thereby 

permanently undermining intramarket 

competition on each exchange. Phlx 

ultimately withdrew the proposal.

3. Internalization 

Internalization opportunities are 

another form of economic inducement 

that exchanges use to attract order flow. 

One such arrangement is referred to as 

a facilitation guarantee, whereby an 

upstairs firm that brings a large 

customer order to the exchange 

(typically at least 50 contracts) may 

trade as principal with a certain 

percentage (up to 40%) of the contracts 

in that order under certain 

circumstances.51 Exchanges use 

facilitation guarantees to induce 

upstairs firms to execute their customer 

orders on the exchange by limiting the 

degree to which the exchange crowd 

may interact with those orders. Like 

specialist guarantees, facilitation 

guarantees modify general exchange 

rules that assign executions based on 

priority, parity, and precedence, and 

like specialist guarantees and payment 

for order flow, exchange rules providing 

facilitation guarantees raise competitive 

and regulatory issues.

Prior to widespread multiple listing, 

exchange rules gave crowd participants 

precedence in trading with all orders. 

As a result, an upstairs firm could not 

trade with any portion of its customer’s 

order with which crowd members 

wanted to trade. After August 1999, 

however, as the options markets began 

to list multiply the most actively traded 

options, competition among exchanges 

for incoming orders intensified, and the 

options exchanges adopted rules that 

provided upstairs firms more 

6130 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

52 In the Matter of the Application of the 

International Securities Exchange, LLC For 

Registration as a National Securities Exchange, 

Release No. 42455 (Feb. 24, 2000) (‘‘ISE Exchange 

Approval’’). When an order is entered into the 

facilitation mechanism, ISE sends a facilitation 

broadcast to crowd participants informing them of 

the proposed transaction. The broadcast contains 

information on the terms and conditions of the 

order, including the facilitation price, and the 

crowd is given ten seconds to respond. The upstairs 

firm entering the facilitation order will be allocated 

40% of the original size of the facilitation order, but 

only after better-priced orders, quotes, and public 

customer orders at the facilitation price are 

executed. In approving the ISE’s rule, the 

Commission noted: ‘‘It is difficult to assess the 

precise level at which guarantees may begin to 

erode competitive market maker participation and 

potential price competition within a given market. 

In the future, after the Commission has studied the 

impact of guarantees, the Commission may need to 

reassess the level of these guarantees. For the 

immediate term, the Commission believes that forty 

percent is not clearly inconsistent with the statutory 

standards of competition and free and open 

markets.’’ Id at text accompanying nn. 118–119.

53See Exchange Act Release Nos. 42835 (May 26, 

2000), 65 FR 35683 (June 5, 2000); 42848 (May 26, 

2000), 65 FR 36206 (June 7, 2000); 42894 (June 2, 

2000), 65 FR 36850 (June 12, 2000); and 47819 (May 

8, 2003), 68 FR 25924 (May 14, 2003) (orders 

approving, respectively, File Nos. SR–CBOE–99–10; 

SR–PCX–99–18; SR–Amex–99–36; and SR–Phlx–

2002–17).

54See Notice of Phlx 80/20 proposal, supra note 

47, 65 FR at 48786.

55For a discussion of the concerns with payment 

for order flow, see SEC Staff Special Study, supra

note 13. See also Phlx Petition, infra note 95 and 

Susquehanna Petition, infra note 96.

56See Exchange Act Release No. 43084 (July 28, 

2000) 65 FR 48406, 48419 (August 8, 2000) 

(proposing Exchange Rules 11Ac1–5 and 11Ac1–6).

57Exchange Act Release No. 42450 (Feb. 23, 

2000), 65 FR 10577, 10584 [‘‘Fragmentation 

Release’’]. A broker must take price (including 

opportunities for price improvement) into 

consideration in determining where to route its 

orders for execution, but price is not the only 

criteria that a broker may consider. It may also 

consider factors such as the trading characteristics 

of the security involved and the cost and difficulty 

of obtaining an execution in a particular market 

center, among other factors.

58The duty of best execution requires a broker to 

seek the most favorable terms reasonably available 

under the circumstances for a customer’s 

transaction. See, e.g., Exchange Act Release Nos. 

43084, 65 FR at 48408 and 37619A (Sept. 6, 1996), 

61 FR 48290, 48322 at text accompanying n. 349 

(Sept. 12, 1996) (adopting Rule 11Ac1–4 and 

amending Rule 11Ac1–1 under the Act, also known 

as the Order Handling Rules).

opportunities to participate in the 

execution of certain customer orders 

they bring to the exchanges. For 

example, ISE adopted a rule in February 

2000 that permits upstairs firms to 

interact as principal with up to 40% of 

orders of 50 contracts or more that the 

firm presents to the exchange after an 

auction and other conditions are 

satisfied.52

After the Commission approved ISE’s 

proposal, each of the other options 

exchanges adopted similar rules.53 To 

qualify for the guarantee, all require the 

facilitation orders to be at least 50 

contracts, and the maximum guarantee 

right is 40% of the contracts in those 

orders. Moreover, if both a specialist 

and an upstairs firm would be entitled 

to a guarantee with respect to the same 

trade, the combined guarantee of the 

two firms may not exceed 40% of the 

contracts to be traded, thereby allowing 

the trading crowd to compete for at least 

60% of any such transaction.54 Unlike 

internalization in the over-the-counter 

equity market, the options exchanges’

rules permit a firm to trade with its own 

customer’s order only after an auction in 

which other members of that market 

have an opportunity to participate in the 

trade at the proposed price or an 

improved price. This auction provides 

some assurance that the customer’s 

order is executed at the best price any 

member in that market is willing to 

offer.

IV. Concerns With Payment for Order 

Flow, Specialist Guarantees, and 

Internalization 

While payment for order flow, 

specialist guarantees, and 

internalization are responses to a more 

competitive marketplace, critics assert 

that these practices are detrimental to 

the options markets because they can 

decrease quote competition, interfere 

with a broker-dealer’s best execution 

obligation, and can conflict with a 

market’s role as an SRO.55

A. Quote Competition 

One concern frequently raised about 

payment for order flow arrangements is 

that they may diminish quote 

competition. Specifically, the concern is 

that a market maker or specialist that 

receives order flow because of a 

payment for order flow arrangement 

will have less need to quote aggressively 

to attract order flow, and as a result, 

spreads may be wider than they 

otherwise would be. A related argument 

is that payment for order flow 

arrangements raise costs for market 

makers and, as a result, the market 

makers may widen spreads to offset the 

costs of paying for order flow. Rules or 

practices that permit or encourage 

internalization may also reduce 

intramarket price competition and, 

therefore, cause spreads to widen.56 In 

addition, because an upstairs firm can 

choose among several exchanges to send 

its order flow, market makers may be 

concerned that if they quote too 

aggressively, the upstairs firm 

facilitating its customers’ orders may 

take those orders to another, less 

competitive, exchange where the 

upstairs firm could internalize a greater 

portion of those orders, possibly at 

prices that are inferior from the 

customers’ perspective. The 

Commission requests comment on these 

concerns. 

Question 1.To what extent, if any, 

does payment for order flow in the 

options markets affect a specialist’s or 

market maker’s incentive to quote 

aggressively?

Question 2. If commenters believe 

that payment for order flow diminishes 

a specialist’s or market maker’s 

incentives to quote aggressively, why 

have spreads narrowed over the past 

few years while payment for order flow 

increased? 

Question 3. Where multiple market 

participants can quote independently 

and incoming orders are allocated to the 

market participant that sets the best 

quote, are market participants more or 

less likely to enter payment for order 

flow arrangements than those on 

markets with less intramarket quote 

competition? 

Question 4. Do current exchange rules 

guaranteeing specialists a certain 

portion of orders affect quote 

competition? To what extent is 

intramarket quote competition 

preserved by requiring that nonspecialist market makers be permitted to 

compete for at least 60% of an order 

without bettering the specialist’s quote? 

Is the harm to quote competition, if any, 

decreased on those markets that permit 

market makers to auto-quote? 

Question 5. Is a market maker’s 

incentive to quote aggressively impacted 

by the percentage of orders that an 

upstairs firm can internalize? For 

example, all things being equal, is a 

market maker less likely to quote 

aggressively if exchange rules or 

customs permit an upstairs firm to 

internalize a substantial portion of each 

order that it brings to the exchange? 

B. Best Execution 

With respect to equity securities, the 

Commission has stated that a broker 

does not necessarily violate its duty of 

best execution by receiving payment for 

order flow (or internalizing its agency 

orders), but the duty also is not 

necessarily satisfied by routing orders to 

a market center that merely guarantees 

an execution at the NBBO.57

Nevertheless, concerns have been raised 

that a broker that routes its customer 

orders to a particular market with which 

it has a payment for order flow 

arrangement may not be meeting its best 

execution obligations with respect to 

those orders.58 Critics of payment for 

order flow arrangements assert that a 

broker that routes its customers’ orders 

pursuant to such an arrangement is 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6131

59See, e.g., letter to Harvey L. Pitt, Chairman, 

SEC, from William J. Brodsky, Chairman & CEO, 

CBOE, (Feb. 10, 2003) wherein CBOE stated: 

‘‘P[ayment] F[or] O[rder] F[low] can induce brokerdealers to decide to maximize firm profits by 

directing their orders to those markets paying the 

most for those orders.’’

60 ISE Exchange Approval, supra note at text 

accompanying n. 118.

61 Id. at n. 118.

62Non-professional or uninformed traders may be 

less likely to understand the ‘‘true’’ value of a 

security and therefore may be willing to pay more 

for it or sell it for less than would a professional 

trader. For a discussion of informed and 

uninformed traders and payment for order flow, see

Allen Ferrell, A Proposal for Solving Payment for 

Order Flow, 74 S. Cal. L. Rev. 1027, 1078–80 (May 

2001).

63 17 CFR 240.11Ac1–6 (b)(1)(ii)–(iii). Exchange 

Act Release No. 43590 (Nov. 17, 2000), 65 FR 75413 

(Dec. 1, 2000).

more likely to be doing so to further its 

own self interest rather than the 

interests of its customers.59

Facilitation guarantees could also 

raise best execution concerns. Where a 

firm can profit by internalizing its 

customers’ orders, it has an incentive to 

take those orders to an exchange that 

permits it, by rule or practice, to 

internalize the largest portion of its 

customers’ orders. In the order 

approving ISE’s exchange application, 

the Commission stated that a brokerdealer that withdraws ‘‘a facilitated 

order that may be price improved 

simply to avoid executing the order at 

the superior price is a violation of a 

broker’s duty of best execution.’’ 60 The 

Commission acknowledged, however, 

that the intermarket nature of such 

conduct might make it difficult for any 

one market to detect and deter such 

abusive trading behavior. Nevertheless, 

the Commission stated that it expects 

the options markets to work together 

through the Intermarket Surveillance 

Group to develop methods and 

procedures to monitor their members’

trading on other markets for possible 

best execution violations.61

Question 6. Do customer orders that 

are routed pursuant to payment for 

order flow arrangements ever receive 

less favorable executions than orders 

not subject to such arrangements? To 

what extent do exchanges’ rules 

requiring that members avoid trading 

through better prices on other exchanges 

ensure that any order, regardless of the 

reason for its being routed to a 

particular exchange, receives at least the 

best published quotation price? 

Some may argue that specialists in the 

options markets establish the prices and 

sizes of their quotes based in part on the 

assumption that their counterparties 

will be other professional traders. The 

desirability of trading with uninformed 

order flow due to the lower risks of 

trading with non-professionals should 

translate into those orders, on average, 

receiving better prices than the 

specialist’s quote.62 Under this 

argument, specialists may use payment 

for order flow as an indirect way of 

providing a better execution to 

uninformed or non-professional orders.

Question 7. Do market makers 

establish the price and size of their 

public quote based on the assumption 

that they may trade with an informed 

professional, which involves more risk 

than trading with an uninformed nonprofessional?

Question 8. If commenters agree that 

public quotes are based on the 

assumption that the market maker may 

trade with a professional, are such 

quotes wider than they would be if 

market makers only received 

uninformed, non-professional orders? 

Question 9. Are market makers 

willing to trade with non-professional 

orders at prices better than their quote? 

Question 10. If the Commission were 

to eliminate payment for order flow 

would non-professional orders get better 

prices? 

Question 11. Do customer orders that 

are internalized in whole or in part on 

an exchange receive less favorable 

executions than orders that are not 

internalized? If so, why? 

Question 12. Do exchange rules 

requiring that an auction occur prior to 

a trade ensure that internalized orders 

are executed at the best available price? 

C. Conflicts Between the Roles of Market 

and SRO 

An exchange is keenly interested in 

maximizing the order flow sent to its 

market because much of the revenue the 

exchange earns come from those orders. 

At the same time an exchange has an 

obligation to enforce its members’ best 

execution obligations. Consequently, an 

SRO has a significant conflict in 

assessing whether an order sent to its 

market would have received a better 

execution on another market. Payment 

for order flow and internalization 

further heighten best execution and 

other regulatory concerns because of the 

conflict that a broker faces between its 

interests and those of its customer. An 

SRO that too closely scrutinizes whether 

its members are meeting their best 

execution obligations could risk driving 

the members to competing exchanges 

with less stringent enforcement 

procedures. 

Exchange-sponsored payment for 

order flow arrangements raise the 

particular issue of whether an SRO, 

which regulates its member brokerdealers, can effectively carry out its 

regulatory obligations with respect to 

best execution enforcement when it also 

requires its market makers to pay fees 

which, by their nature, are to be used 

solely to pay firms to send orders to the 

exchange. 

Question 13. Is an SRO’s enforcement 

of its members’ best execution 

obligation affected by the SRO’s interest 

in attracting and retaining order flow 

from those same members? 

Question 14. To what extent do 

payment for order flow practices 

generally, or exchange-sponsored 

payment for order flow specifically, 

exacerbate the conflict an SRO has in 

carrying out its obligation to enforce its 

members’ best execution obligation? 

Question 15. Does exchangesponsored payment for order flow affect 

specialists’ or market makers’ incentives 

to quote aggressively differently than 

other types of payment for order flow? 

If so, in what respects? 

Question 16. What safeguards, if any, 

should an options exchange have in 

place to ensure that it can carry out its 

regulatory responsibilities with respect 

to those of its members that accept 

payment for order flow or internalize 

trades? For example, would an 

independent SRO to oversee how 

brokers meet their best execution 

obligations be feasible and desirable? 

V. Regulatory Initiatives 

Traditionally, the Commission has not 

used restrictions on payment for order 

flow as a means to address concerns that 

the practice may raise. Instead, the 

Commission and the markets have taken 

steps to improve market transparency 

and price competition, which, in turn, 

are designed to address many of these 

concerns. As discussed below, these 

steps include implementing Exchange 

Act Rule 11Ac1–6, converting to 

decimal pricing, implementing an 

intermarket linkage, applying the Quote 

Rule to options, and removing certain 

barriers to transparency and 

competition as a result of the 

enforcement settlement between the 

Commission and the floor-based options 

exchanges. 

A. Exchange Act Rule 11Ac1–6 

Rule 11Ac1–6, adopted in November 

2000, requires broker-dealers to publish 

quarterly reports detailing where they 

route their customer orders for 

execution and the relationship the 

broker-dealer has with the venues to 

which it routes those orders, including 

any profit-sharing or payment for order 

flow arrangements the broker-dealer 

may have with those venues.63 This rule 

6132 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

64Boehmer, Ekkehart, Robert Jennings, and Li 

Wei, Public Disclosure and Private Decisions: The 

Case of Equity Market Execution Quality (August 

31, 2003 Draft), available at http://www.nyse.com.

Wei is from the NYSE’s Research Division. Boehmer 

was a Director of Research at the NYSE while the 

research for the study was being completed. The 

authors studied order-routing behavior for NYSElisted stocks from June 2001 to February 2003 and 

found that market share was significantly negatively 

related to effective spreads and execution speed. 

They determined that this fact was consistent with 

the argument that brokers use information in Rule 

11Ac1–5 reports to make order routing decisions. 

Based on the authors’ estimates, a one-cent increase 

in effective spreads reduces monthly order flow by 

522,060 shares for each stock traded. In addition, 

a one-second increase in execution speed resulted 

in a loss of 89,760 shares per stock. Id. at 17.

65Exchange Act Release No. 43590 (Nov. 17, 

2000), 65 FR 75413 (Dec. 1, 2000).

66See supra notes 13–17 and accompanying text.

67Exchange Act Release Nos. 47231 (Jan. 22, 

2003), 68 FR 4258 (Jan. 28, 2003) (order 

permanently approving OPRA’s BBO proposal); and 

46992 (Dec. 13, 2002), 67 FR 78031 (Dec. 20, 2002) 

(approving OPRA’s BBO proposal for 120 days).

68 If the same best-priced bid or offer is quoted 

on more than one exchange, the exchange that is 

quoting at that price for the largest number of 

options contracts will be identified by OPRA as the 

market that is quoting the best bid or offer. If the 

same best bid or offer for the same number of 

options contracts is quoted on more than one 

exchange, the exchange that was first in time to 

quote that bid or offer for that number of contracts 

will be identified as the market with the BBO.

69Markets may, consistent with their own 

exchange rules, disseminate bids and offers that 

improve the NBBO by less than $0.05, or that 

increase the size at a given quote by fewer than ten 

contracts. Such improvements, however, would not 

be reflected in the OPRA NBBO. As discussed 

further below, all of the registered options 

exchanges currently set the minimum quotation 

increment at $0.05 for option issues quoted under 

$3 a contract and at $0.10 for option issues quoted 

at $3 and greater. As a result, currently, no 

exchange member may quote an increment through 

one of the registered options exchanges that is less 

than $0.05. Accordingly, OPRA’s NBBO reflects the 

best-priced quotations on the registered options 

exchanges.

70Exchange Act Release No. 42360 (Jan. 28, 

2000), 65 FR 5003 (Feb. 2, 2000).

71Exchange Act Release No. 44568 (July 18, 

2001), 66 FR 38390 (July 24, 2001).

72See, e.g., The Impact of Decimalization on the 

Nasdaq Stock Market, Final Report to the SEC 

Prepared By Nasdaq Economic Research and 

Decimalization of Trading on the New York Stock 

Exchange: A Report to the Securities and Exchange 

applies to transactions in options as 

well as those in equity securities. These 

quarterly reports provide investors with 

information about possible motivations 

a broker-dealer may have in routing its 

customers’ orders to a particular venue. 

Rule 11Ac1–6 is limited, however, in 

that it does not provide information on 

the execution quality that a market 

center offers once it receives an order. 

That information is required for equity 

securities, but currently not for options, 

by Exchange Act Rule 11Ac1–5, which 

the Commission adopted at the same 

time as Rule 11Ac1–6.

Rule 11Ac1–5 requires each equity 

market center, including each exchange, 

to publish monthly reports detailing the 

execution quality that the market center 

provides for equity orders that are 

routed to it for execution. Rule 11Ac1–

5 reports allow market participants to 

evaluate, among other things, which 

markets have the lowest spreads, which 

execute orders the quickest, and which 

are the most likely to price improve 

orders or to execute orders at prices 

inferior to the prevailing best bid or 

offer. 

A recent study of NYSE-listed 

securities using Rule 11Ac1–5 reports 

found that ‘‘reports based on SEC Rule 

11Ac1–5 appear to have value beyond 

public trade and quote information 

available elsewhere.’’ 64 The researchers 

found that the value of the reports 

‘‘qualifies industry complaints about the 

high cost of producing this data, 

because the additional price 

competition should benefit all market 

participants.’’ The study further 

concluded that ‘‘the Securities and 

Exchange Commission’s emphasis on 

disclosure as a means of affecting public 

policy can produce beneficial effects for 

many market participants, at least in the 

case of equity trading. It appears that 

publishing standardized execution 

quality statistics encourages (coerces) 

brokers to consider these statistics in 

their routing decisions.’’ The authors 

found that although ‘‘brokers appear to 

use other, publicly available data for 

routing decisions prior to the SEC’s 

enactment of the rule, the reliance on 

the ‘non-official’ statistics decreases 

after Rule 11Ac1–5 becomes effective.’’

When it adopted Rule 11Ac1–5 and 

Rule 11Ac1–6, the Commission 

considered but decided not to apply 

Rule 11Ac1–5 to the options markets, 

stating:

The Commission continues to believe that 

there is a need for improved disclosure of 

execution quality in the options markets, 

particularly now that there is widespread 

trading of options on multiple exchanges and 

expanding payment for options order flow. 

Nevertheless, potentially difficult issues 

would have to be addressed before options 

could be included within Rule 11Ac1–5. For 

example, a consolidated BBO is not, at this 

time, calculated and disseminated for options 

trading. A consolidated BBO is an essential 

element for nearly every statistical measure 

in the Rule, such as calculating price 

improvement and classifying types of limit 

orders (e.g., inside-the-quote and at-the-quote 

limit orders). Although each exchange 

potentially could calculate its own 

consolidated BBO, the calculations might 

vary at times and fail to provide a uniform 

basis for comparable statistics. In addition, 

categorization of orders on a security-bysecurity basis would be much less practical 

for the options markets, where there may be 

hundreds of series of options for one 

underlying security.65

In the SEC staff study discussed 

above,66 the staff made the following 

observations regarding market quality 

information available to broker-dealers 

in the options markets:

• Broker-dealers do not have adequate 

market execution quality information to 

compare reliably the quality of executions 

between specialist firms. 

• The options exchanges are developing 

execution quality reports, but these reports 

may not enable broker-dealers that route 

customer orders adequately to compare 

execution quality on different options 

exchanges because each report uses different 

measures and methodologies to calculate 

execution quality. 

• An NBBO would facilitate the creation of 

uniform measures of execution quality. 

• Independent execution quality vendors 

have been unable to develop reliable 

execution quality reports for order routing 

firms because the exchanges have not 

provided them with adequate execution data.

Since the study was conducted, 

OPRA, which transmits quotations and 

trade reports from the options markets 

to vendors for dissemination to the 

public, has developed a consolidated 

NBBO data feed for the options markets 

that is available to vendors.67 The NBBO 

that OPRA disseminates is the highest 

priced bid and the lowest priced offer 

quoted at the time on any of the five 

registered options exchanges.68 The 

minimum price increment for purposes 

of the NBBO is no less than $0.05, and, 

absent a change in the NBBO, the 

minimum size increment for purposes 

of the NBBO is no fewer than 10 

contracts.69

Below, the Commission seeks 

comments on whether it should extend 

Rule 11Ac1–5 to the options markets. 

B. Decimals 

On January 28, 2000, the Commission 

ordered the SROs to convert from 

fractional quotes to quotes in 

decimals.70 The conversion from 

fractions to decimals for quotations in 

all equity securities and options was 

successfully completed on April 9, 

2001.71 As a result, the minimum 

quoting increment for equity securities 

narrowed from 1⁄16th of a dollar 

($0.0625) to a penny ($0.01). The 

minimum quoting increment for option 

issues quoted under $3.00 a contract 

was set at $0.05 (down from 1⁄16th or 

$0.0625) and for options issues quoted 

at $3.00 and greater it was set at $0.10 

(down from 1⁄8th or $0.125). Research 

conducted with respect to the equities 

markets supports the conclusion that 

the move to decimal pricing has 

contributed to a substantial decrease in 

spreads in the equities markets.72 The 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6133

Commission (Sept. 7, 2001). See also Hendrik 

Bessembinder, ‘‘Trade Execution Costs and Market 

Quality after Decimalization,’’ Journal of Financial 

and Quantitative Analysis, forthcoming (finding 

that quoted and effective spreads declined 

substantially on Nasdaq and NYSE after 

decimalization).

73See ONLINE TRADING In Slow Times, Net 

Brokers Look For New Revenue, Investor’s Business 

Daily, Section A, p.5 (August 3, 2001): ‘‘Under 

decimals, the smallest spread between the bid and 

offer price for a stock is now just a penny. Prior to 

the Nasdaq’s switch to decimals in April, spreads 

were at least 1/16, or .0625, of a dollar. That smaller 

spread is eating into the profit of market-makers 

like Knight Trading Group Inc. That’s forced them 

to cut back on a practice called payment for order 

flow. In return for a commitment to send Knight 

much of their customers’ orders, Knight has been 

paying brokerages up to a couple of dollars on each 

trade. Now that they’re struggling to remain 

profitable, market-makers can’t afford to pay out as 

much.’’ See also comments of Bernard L. Madoff, 

Bernard L. Madoff Investment Securities LLC, at 

SEC Market Structure Hearing, October 29, 2002: ‘‘I 

remember everybody saying ban payment for order 

flow. They’re still saying ban payment for order 

flow. We don’t even pay for order flow any longer, 

although we’re considering going back to paying for 

order flow. [A]ll of these things are constantly 

resurfac[ing].’’

74One industry study suggests that quoted and 

effective spreads for options decreased from the 

period before decimals to the period after decimal 

implementation. Report on the Impact of Decimal 

Pricing, prepared by CBOE (Sept. 10, 2001). CBOE 

studied certain options on securities listed on 

NYSE, Nasdaq and AMEX and found that quoted 

and effective spreads decreased from the predecimal to the post decimal period. CBOE 

discounted the results, however, given that spreads 

for a control group of securities that had shifted to 

decimals prior to the study period also declined 

over the period. CBOE further stated that the lack 

of a significant decline in spreads was expected 

given that the change in minimum quoting 

increments in the options markets (i.e., from 

$0.0625 to $0.05 and from $0.125 to $0.10, 

depending on the price of the option) was much 

less dramatic than the change in the equity markets 

where the minimum quoting increment declined 

from $0.0625 to $0.01.

75On October 19, 1999, the Commission directed 

the options exchanges to file a national market 

system plan for linking the options markets. 

Exchange Act Release No. 42029 (Oct. 19, 1999), 64 

FR 57674 (Oct. 26, 1999). The options exchanges 

submitted multiple plans on January 19, 2000. 

Exchange Act Release No. 42456 (Feb. 24, 2000), 65 

FR 11402 (March 2, 2000). CBOE and Amex 

submitted identical plans. PCX and Phlx submitted 

plans that were distinct from the CBOE/Amex plan 

and from each other. On July 28, 2000, the 

Commission approved the plan proposed by Amex 

and CBOE, which ISE joined after the Commission 

approved its exchange application. Exchange Act 

Release No. 43086 (July 28, 2000), 65 FR 48023 

(August 4, 2000) (‘‘Linkage Approval Order’’). In 

November 2000, PCX and Phlx also joined that 

plan. Exchange Act Release Nos. 43573 (Nov. 16, 

2000), 65 FR 70851 (Nov. 28, 2000) (admitting Phlx) 

and 43574 (Nov. 16, 2000) 65 FR 70850 (Nov. 28, 

2000) (admitting PCX).

76See Exchange Act Section 11A(a)(1)(C)(iv). 15 

U.S.C. 78k–1(a)(1)(C)(iv).

77Section 8(c) of the Plan for the Purpose of 

Creating and Operating an Intermarket Option 

Linkage (‘‘Linkage Plan’’) states: ‘‘The Participants 

agree that, absent reasonable justification and 

during normal market conditions, members in their 

markets should not effect Trade-Throughs.’’

78The Linkage Plan does not prohibit one market 

from trading through a superior quote on another 

market. Rather, it requires market participants to 

avoid initiating a trade-through, unless an 

exception applies (e.g., the bid or offer traded 

through was being disseminated from an exchange 

whose quotes were not firm with respect to that 

option class). In addition, under the Linkage Plan, 

if the party whose quote was traded through 

complains, the market participant that initiated the 

trade-through must (unless it cancels the offending 

trade) either (1) send an order through the linkage 

to satisfy the quote that was traded through or (2) 

correct the price of the trade that constituted the 

trade-through to a price at which a trade-through 

would not have occurred. The price correction must 

then be reported through OPRA. See Section 8 of 

the Linkage Plan. If a market participant receives an 

order when it is not quoting at the NBBO, it may 

execute the order at the NBBO without violating the 

Linkage Plan. Linkage Approval Order, 65 FR at 

48026. Notwithstanding the lack of a trade-through 

prohibition in the Linkage Plan, a broker-dealer that 

exhibits a pattern or practice of initiating tradethroughs may be in violation of the securities laws 

and rules, including best execution principles and 

SRO rules regarding just and equitable principles of 

trade.

79See Linkage Approval Order, 65 FR at 48029.

80Exchange Act Rule 11Ac1–1, 17 CFR 

240.11Ac1–1.

81Exchange Act Release No. 43591 (Nov. 17, 

2000), 65 FR 75439 (Dec. 1, 2000). In addition to 

amending the Quote Rule to apply to options, the 

Commission adopted a trade-through disclosure 

rule. Under that rule, Exchange Act Rule 11Ac1–7, 

which the Commission repealed in December 2002, 

broker-dealers, with certain exceptions, were 

required to disclose to their customers the fact that 

the customers’ orders to buy or sell listed options 

were executed at prices inferior to the best quotes 

that were published at the time the customers’

orders were executed. The rule did not apply to 

customer orders that were executed on options 

markets that participated in an intermarket linkage 

plan approved by the Commission that had 

provisions reasonably designed to limit intermarket 

trade-throughs. See id., 65 FR at 75443–47. See also

Exchange Act Release No. 47013 (Dec. 17, 2002), 67 

FR 79454 (Dec. 27, 2002) (repealing Rule 11Ac1–

7).

move to decimal pricing in the equities 

markets, and, in particular, the resulting 

narrowing of spreads, has been cited as 

one of the factors that has led to a 

decrease in the use of payment for order 

flow with respect to equity securities.73

Research is more limited, however, on 

the impact on spreads of the shift from 

quoting in fractions to quoting in 

decimals (and any resulting impact the 

shift might have had on payment for 

order flow) in the options markets.74

While the Commission is not aware of 

any comprehensive studies showing 

how narrower spreads might impact 

payment for order flow in the options 

markets, experience in the equities 

markets suggests that, as the amount of 

profit a dealer can make from trading 

the spread declines, so too does the 

amount of money that dealer is willing 

to pay for attracting the orders with 

which it interacts.

It is conceivable that the same result 

could occur in the options markets if 

options were quoted in one-cent 

increments. In other words, widespread 

payment for order flow may suggest that 

current pricing in the options markets is 

inefficient. If payment for order flow is 

a symptom of inefficient pricing in the 

options markets, removing the five-cent 

and ten-cent minimum price increments 

in those markets might allow the 

markets to price options contracts more 

accurately, which could result in a 

narrowing of spreads. If spreads 

narrowed, each transaction would be 

worth less to market participants that 

profit from those spreads and, as a 

result, they would be less likely to pay 

to attract orders or else they would be 

willing to pay less to attract them. At 

the same time, however, penny pricing 

in the options markets could greatly 

increase quote traffic, which could 

diminish the quality and timeliness of 

options quotation information. Below, 

the Commission seeks comments on 

how penny pricing in the options 

markets could impact payment for order 

flow.

C. Intermarket Linkage 

In early 2003, the options exchanges 

began sending orders through a linkage 

designed to facilitate the routing of 

orders between exchanges.75 The 

intermarket linkage is based on the 

national market system principle that 

brokers should have the ability to reach 

easily a better price in another market 

to encourage efficient pricing and best 

execution of customer orders.76 The 

linkage plan requires exchanges to avoid 

executing trades at prices inferior to the 

best available price (called a ‘‘tradethrough’’).77

The linkage provides market 

participants with an automated means 

for accessing the best prices in the 

options markets, no matter which 

exchange is offering those prices at a 

given time. Moreover, by discouraging 

market participants from trading at 

prices inferior to the NBBO, the linkage 

will likely enhance price competition 

across markets.78 Therefore, the linkage 

may help to ameliorate some of the 

competitive and best execution 

concerns that payment for order flow 

and internalization raise.79

D. Applying the Quote Rule to Options 

In December 2000, the Commission 

amended Exchange Act Rule 11Ac1–1,80

(‘‘Quote Rule’’) to apply it to options, in 

another move designed to improve 

market transparency and price 

competition in the options markets.81

The Quote Rule requires national 

securities exchanges and associations to 

establish procedures for collecting from 

their members bids, offers, and 

quotation sizes for reported securities 

and for making that information 

available to vendors. The rule also 

6134 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

82See Exchange Act Release No. 14415 (Jan. 26, 

1978), 43 FR 4342 (adopting Rule 11Ac1–1 for 

equity securities). See also Exchange Act Release 

No. 14711 (April 27, 1978), 43 FR 18556 (deferring 

effective date of rule to August 1978).

83Exchange Act Release No. 14415, supra note at 

n.49.

84 Id. at 75442.

85Exchange Act Release No. 43085 (July 28, 

2000), 65 FR 47918, 47925 (August 4, 2000).

86See Exchange Act Release No. 43268 (Sept. 11, 

2000) (‘‘SEC Settlement Order’’) and United States

v. American Stock Exchange LLC, et al, Proposed 

Order, Stipulation and Competitive Impact 

Statement, 65 FR 57829 (Sept. 26, 2000). In the SEC 

Settlement Order, the Commission found, among 

other things, that the options exchanges listed in 

the settlement failed to comply with Exchange Act 

Rule 19c—5 as incorporated into their respective 

rules by refraining from multiply listing certain 

options listed on a single exchange that were 

available for multiple listing. SEC Settlement Order 

at text accompanying n. 3.

87See SEC Settlement Order, supra note, 65 FR 

at 57840.

88Exchange Act Release No. 44521 (July 6, 2001), 

66 FR 36809 (July 13, 2001).

89Exchange Act Release Nos. 43252 (Sept. 6, 

2000), 65 FR 55653 (Sept. 14, 2000) (SR–Amex–00–

50); 43253 (Sept. 6, 2000), 65 FR 55655 (Sept. 14, 

2000) (SR–Amex–00–52); 43251 (Sept. 6, 2000), 65 

FR 55658 (Sept. 14, 2000) (SR–CBOE–00–45); 44131 

(March 29, 2001), 66 FR 18136 (April 5, 2001) (SR–

PCX–01–11); and 44057 (March 9, 2001), 66 FR 

15312 (SR–Phlx–01–03).

90On April 15, 2003, the options exchanges filed 

with the Commission a proposal to amend the 

OPRA plan to satisfy this obligation. See OPRA–

2003–01.

91SEC Settlement Order, supra note 86, 65 FR at 

57841.

92See Battalio et al, supra note. The authors 

suggest that the increased competition from 

multiple listing and the threat of regulatory action 

in the form of an intermarket linkage were sufficient 

to improve execution quality in the options markets 

to a level comparable to that of the equities markets 

and therefore additional regulation may not be 

required.

requires that broker-dealers’ quotations 

be firm, subject to certain exceptions.

The Quote Rule has applied in the 

equities markets since 1978.82 The rule 

was not applied to options at that time, 

however, because they had only begun 

to trade a few years earlier.83 Although 

each of the options exchanges had 

adopted rules requiring their market 

makers or specialists to have firm quotes 

for public customers, the rules did not 

extend to other market participants and 

were subject to exceptions unavailable 

in the Commission’s Quote Rule.84 In 

the release proposing to apply the Quote 

Rule to options, the Commission stated:

The reliability and availability of quotation 

information are basic components of a 

national market system and are needed so 

that broker-dealers are able to make best 

execution decisions for their customers’

orders, and customers are able to make order 

entry decisions. Quotation information has 

significant value to the marketplace as a 

whole because a quotation reflects the 

considered judgment of a market professional 

as to the various factors affecting the market, 

including current levels of buying and selling 

interest. Both retail and institutional 

investors rely on quotation information to 

understand the market forces at work at any 

given time and to assist in the formulation of 

investment strategies.

* * * * *

The Commission is proposing a firm quote 

rule for options [in conjunction with a tradethrough disclosure rule] to ensure that the 

published quotes of options exchanges are 

accessible to orders from both customers and 

broker-dealers. Currently, the options 

exchanges’ quotes need not be firm for 

broker-dealer orders. Therefore, market 

markers on an exchange may not be able to 

trade with quotes on competing exchanges 

even when these market makers are 

representing customer orders. Yet market 

makers are expected to match the prices on 

competing exchanges or to trade with those 

quotes, before trading at an inferior price. 

* * * A firm quote requirement for options 

is needed to ensure that these quotes will, in 

fact, be honored when orders are routed from 

other markets.85

E. Enforcement Settlement 

The September 2000 regulatory 

settlement between Amex, CBOE, Phlx, 

PCX, and the Commission as well as a 

separate settlement between these 

exchanges and the Department of Justice 

were also designed to enhance 

transparency and competitiveness in the 

options markets.86 Among other things, 

in the settlement with the Commission, 

the options exchanges agreed to remove 

or amend certain rules and procedures 

that may have hindered or prevented 

the multiple listing of options. For 

example, the exchanges were required 

to remove provisions from the JointExchange Options Plan (‘‘JEOP), which 

sets forth procedures that the options 

exchanges followed to list new options 

to reduce the amount of advance notice 

that an exchange was required to 

provide before it could begin trading an 

option that was already trading on 

another exchange.87 In July 2001, the 

Commission approved a proposal filed 

by all of the options exchanges as well 

as the Options Clearing Corporation to 

replace the JEOP with the Options 

Listing Procedures Plan.88

Moreover, the exchanges agreed to 

adopt procedures that prevent the 

exchanges from threatening, harassing, 

or retaliating against their members that 

seek to trade options already traded on 

another exchange.89 In addition, the 

exchanges agreed to make changes to 

the way in which OPRA acquires and 

allocates market data transmission 

capacity so that OPRA is not used as a 

means to limit the multiple listing of 

options.90

Finally, the settlement directs the 

exchanges to amend their then-existing 

rules governing their automated 

quotation and execution systems to 

increase incentives to quote 

competitively.91 Some of the 

enhancements that have been 

implemented in connection with the 

Settlement Order are discussed in 

Section III B4 above.

VI. Additional Steps That Could Be 

Taken To Address Concerns About 

Payment for Order Flow, Specialist 

Guarantees, and Internalization 

There are several possible regulatory 

alternatives that the Commission could 

pursue to address concerns with 

payment for order flow, specialist 

guarantees, and internalization. These 

alternatives range from taking no 

regulatory action at this point to 

banning these arrangements. The 

Commission seeks comments on the 

alternatives it could pursue to address 

concerns with these arrangements. 

A. Should the Commission Take Action 

at This Point? 

As discussed above, the options 

markets have undergone fundamental 

changes in the past few years. Options 

exchanges and market participants in 

those markets continue to adapt to the 

regulatory changes, including the 

implementation of an intermarket 

linkage plan, application of the Quote 

Rule, imposition of an order routing 

disclosure rule, and the requirement to 

price options in decimals. Competition 

among the options markets has led to 

the development of systems that permit 

greater intramarket competition, which 

has narrowed spreads. Some 

commentators have suggested that 

competitive forces in the options 

markets have shown themselves 

sufficient to increase the quality of 

execution and no further regulatory 

action is needed at this time.92

Question 17. Do recent regulatory 

changes together with competitive 

forces in the options markets make 

additional regulatory action at this time 

unnecessary? 

Question 18. What would be the 

likely consequences to the options 

markets in terms of competition and 

execution quality should the 

Commission decide to take no 

regulatory action at this time? 

Specifically, do commenters believe that 

the current trend toward narrower 

spreads in the options markets could 

itself eliminate payment for order flow, 

specialist guarantees, and 

internalization? 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6135

93See SEC, Report on the Feasibility and 

Advisability of the Complete Segregation of the 

Functions of Dealer and Broker (June 20, 1936) 

(‘‘Segregation Study’’).

94Letter to Harvey L. Pitt, Chairman, SEC from 

Salvatore F. Sodano, Chairman & CEO, Amex (Feb. 

10, 2003).

95Letter to Jonathan G. Katz, Secretary, SEC, from 

Meyer S. Frucher, Chairman & CEO, Phlx, (Feb. 3, 

2003), Petition for Rulemaking File No. 4–474, 

(‘‘Phlx Petition’’).

96See Letter to Jonathan G. Katz, Secretary, SEC, 

from Joel Greenberg, Chief Legal Officer, 

Susquehanna International Group, LLP, re 

Application for Exemptive Relief from Exchange 

Sponsored Payment for Order Flow Programs (June 

11, 2003), Petition for Rulemaking File No. 4–474, 

(‘‘Susquehanna Petition’’). Susquehanna states that 

it is a market maker on every U.S. options exchange 

other than ISE, that it makes a market in 2000 

options classes and acts as a specialist or designated 

primary market maker in some options classes.

97 17 CFR 201.192.

98See Phlx Petition, supra note. Phlx submitted 

its petition pursuant to Rule 192 of the 

Commission’s Rules of Practice. 17 CFR 201.192. 

Phlx would exclude from its proposed prohibition 

payment for order flow arrangements made directly 

between individual exchange members or between 

an individual member and a non-member brokerdealer. It would also exclude programs or 

arrangements whereby an exchange provides its 

members with volume discounts or rebates or 

programs in which the exchange shares market data 

revenues with its members.

99 15 U.S.C. 78k–1.

B. Should the Commission Require 

Brokers to Rebate All or a Portion of 

Payments They Receive? 

One of the principal concerns about 

payment for order flow is that it creates 

a conflict with a broker’s best execution 

obligation. Requiring brokers to rebate 

to their customers any payments they 

receive in exchange for routing those 

customers’ orders to a particular 

exchange may mitigate much of the 

conflict. 

Question 19. Should brokers that 

receive payment for order flow be 

required to rebate all or a certain portion 

of those payments to their customers or 

demonstrate that the economic benefit 

of payment for order flow has been 

passed on to customers? If so, how 

should the amount of any such rebate be 

determined, and how would a firm 

demonstrate that it passed the payment 

for order flow benefit to customers?

Question 20. How would any noncash inducements to route order flow be 

valued for purposes of any such rebate? 

C. Should the Commission Ban Payment 

for Order Flow, Specialist Guarantees, 

and Internalization? 

The Commission could decide that 

payment for order flow, specialist 

guarantees, and internalization in the 

options markets impair the integrity of 

those markets and pose harm to 

investors and ban such arrangements or 

significantly limit them. 

Question 21. What would be the effect 

of banning all payment for order flow 

arrangements in the options markets? If 

the Commission determined that a ban 

on payment for order flow were 

warranted, would a ban only on cash 

payments be sufficient or would noncash inducements also have to be 

banned? If commenters believe that the 

Commission should impose such a ban, 

could such a ban be easily evaded in 

light of the numerous forms that 

payment for order flow arrangements 

can take? 

Question 22. If the Commission were 

to ban all payment for order flow, but 

continue to permit firms to internalize 

their customers’ orders, would it 

provide an unfair advantage to 

integrated firms that have customer 

order flow they can internalize? If a ban 

on payment for order flow unfairly 

advantaged integrated firms with broker 

and dealer operations, should the 

Commission revisit the issue of whether 

firms should be permitted to operate 

both as a broker and as a dealer for 

customer options orders? 93

Question 23. Should the Commission 

ban some or all specialist guarantees 

and internalization (i.e., dealer 

participation arrangements) in the 

options markets? Should any such ban 

only be done in conjunction with a ban 

on payment for order flow? 

Question 24. What would be the 

impact, if any, on competition in the 

options markets if the Commission were 

to ban either payment for order flow or 

dealer participation arrangements 

without banning the other type of 

arrangement? 

Question 25. What would be the 

impact of a complete ban on all such 

practices? For example, if the 

Commission banned payment for order 

flow and dealer participation 

arrangements, who would benefit? 

Would specialists and market makers 

quote better prices? Would they retain 

the economic benefit they now share 

with order entry firms? What effect 

would a ban have on non-dominant 

markets or firms seeking to attract order 

flow from the dominant market 

participants? 

Question 26. In response to a recent 

request for the views of the options 

markets on payment for order flow 

arrangements, one of the markets stated 

that the Commission’s review of 

payment for order flow and 

internalization should not be limited to 

the options markets but rather should 

include the equities markets as well.94

Are there differences between the 

equities and options markets that 

warrant different treatment? If so, what 

are those differences? If different 

treatment is not warranted, should the 

Commission consider a market-wide 

ban on payment for order flow and 

dealer participation arrangements?

D. Should the Commission Ban Only 

Exchange-Sponsored Payment for Order 

Flow? 

On February 3, 2003, Phlx filed with 

the Commission a petition for 

rulemaking that asks the Commission to 

ban exchange-sponsored payment for 

order flow programs, citing many of the 

concerns about payment for order flow 

discussed above.95 Similarly, on June 

11, 2003, Susquehanna International 

Group, LLP (‘‘Susquehanna’’) requested 

that the Commission exempt it from 

SRO rules that require it to contribute to 

exchange-sponsored payment for order 

flow programs.96 In the alternative, 

Susquehanna requested that the 

Commission treat the exemptive 

application as a petition for rulemaking 

under Rule 192 of the SEC’s Rules of 

Practice 97 to repeal transaction and 

marketing fees adopted by various 

options exchanges.

1. Phlx Petition 

In its petition, Phlx asks the 

Commission to adopt a rule banning 

exchange-sponsored options payment 

for order flow programs.98 According to 

Phlx, exchange-sponsored payment for 

order flow arrangements raise a number 

of concerns. First, Phlx believes that 

such arrangements can interfere with 

market forces by ‘‘creating a known and 

stable price point (the exchangemandated fee) that affects payment for 

order flow negotiations.’’

Second, Phlx argues that exchangesponsored payment for order flow 

arrangements can have detrimental 

effects on market makers by requiring 

them effectively to subsidize the 

specialists’ order flow payments. Phlx 

contends that this subsidization raises 

costs for market makers, which, to cover 

those costs, may have to widen their 

spreads or reduce the level of liquidity 

they provide. Phlx believes that this 

subsidization is inconsistent with 

Section 11A of the Exchange Act, which 

requires fair competition among brokers 

and dealers.99

Finally, Phlx asserts that exchangesponsored payment for order flow 

arrangements provide a potential 

disincentive for an SRO to police its 

members in complying with their 

regulatory obligations. 

For these reasons, Phlx requests that 

the Commission adopt a rule that would 

prohibit: (1) An options exchange from 

6136 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

100See supra note 60 and accompanying text.

101Letter to Harvey L. Pitt, Chairman, SEC, from 

William J. Brodsky, Chairman & CEO, CBOE (Feb. 

10, 2003).

102For point of reference, see Exchange Act 

Release No. 46514 (Sept. 18, 2002), 67 FR 60267 

(Sept. 18, 2002) (order approving File No. SR–ISE–

2001–19 regarding facilitation of customer orders, 

wherein the Commission stated its belief that: ‘‘in 

the ISE’s fully automated market, a 10-second 

response period will afford electronic crowds 

sufficient time to compete for customer orders 

submitted by an E[lectronic] A[ccess] M[ember] into 

the Exchange’s Facilitation Mechanism, thereby 

promoting just and equitable principles of trade, 

protecting investors and the public interest, and not 

imposing any burden on competition’’ and ‘‘the 

Commission believes that the timeframes necessary 

for exposure and execution of orders be adjudged 

in light of that marketplace’s model. For this reason, 

the Commission does not believe that a fully 

automated market such as the ISE should be tied 

to timeframes relevant to the procedures of a floorbased exchange.’’)

organizing, sponsoring, or administering 

a payment for order flow program in 

connection with the routing of options 

orders; (2) an options exchange from 

imposing fees or assessments to fund 

payment for order flow payments in 

connection with the routing of options 

orders; and (3) an options exchange 

member from participating in any 

options payment for order flow program 

that is organized, sponsored, or 

administered by an options exchange or 

by any group or association of 

unaffiliated members. 

2. Susquehanna Request 

In its letter, Susquehanna asks the 

Commission, by rulemaking or order, to 

exempt it from SRO rules that require 

Susquehanna and other similarly 

situated firms to contribute to exchangesponsored payment for order flow 

programs. Susquehanna argues that 

such programs are detrimental to the 

markets and market participants in a 

number of respects. For example, 

Susquehanna believes that forcing 

market makers to participate in the 

programs will ultimately cause them to 

widen their spreads to pay for the 

programs, which will raise investors’

transaction costs. Susquehanna also 

believes that such programs place 

exchange market makers at a 

competitive disadvantage versus market 

participants that are not members of the 

exchange, which are not required to pay 

the exchange-imposed fees. 

Susquehanna contends that exchangesponsored payment for order flow 

programs, the fees of which are assessed 

on a per contract basis, unfairly 

discriminate against firms such as 

Susquehanna, which transact a large 

number of contracts. Moreover, 

Susquehanna argues that exchangesponsored payment for order flow 

arrangements drain market maker 

resources away from other services that 

they could offer to their customers, such 

as improvements in products, 

technology, customer service, and 

communications. 

In addition, Susquehanna contends 

that such programs create a conflict of 

interest for SROs that administer the 

programs at the same time they are 

tasked with ensuring that their members 

meet their best execution obligations. 

The firm also contends that such 

programs damage investor confidence 

by leading investors to believe that their 

orders are routed to the venues that pay 

for order flow rather than to those 

venues that offer the best price or other 

execution terms. Finally, Susquehanna 

contends that such programs can be 

administered in an arbitrary and 

potentially discriminatory manner. For 

all of these reasons, Susquehanna 

requests that the Commission exempt it 

(and similarly situated firms) from all 

such exchange-sponsored payment for 

order flow programs. 

The Commission seeks comment 

generally on the Phlx Petition and on 

the Susquehanna Petition and 

specifically is requesting comments on 

the following issues raised in those 

petitions. 

Question 27. What would be the effect 

on the options markets and market 

participants if the Commission were to 

restrict only those payment for order 

flow arrangements that are sponsored or 

sanctioned in some way by a registered 

options exchange, as Phlx has proposed 

in its petition? In particular, would such 

a restriction favor a specialist that can 

be assured of trading with the largest 

proportion of order flow routed to its 

exchange? In other words, would such 

a ban unfairly disadvantage an exchange 

on which market makers compete more 

aggressively with the specialist? 

Question 28. Would banning 

exchange-sponsored programs, while 

continuing to permit other types of 

payment for order flow and dealer 

participation arrangements, address the 

concerns discussed above regarding 

wider spreads, best execution, and SRO 

conflicts of interest? 

E. Should the Commission Establish 

Uniform Rules and Enforcement 

Standards Regarding Internalization 

and Specialist Guarantees? 

With respect to facilitation 

guarantees, the Commission has stated 

that it is a violation of a broker-dealer’s 

best execution obligation to withdraw a 

facilitated order that may be price 

improved on one market to avoid 

executing the order at the superior 

price.100 CBOE contends, however, that 

in the absence of uniform rules and 

policies across all options exchanges 

that would curb such trading behavior, 

none of the options exchanges is able, 

on its own, to prevent it. CBOE 

contends that industry efforts over the 

past several months to address 

potentially abusive facilitation practices 

have been unsuccessful due to the 

exchanges’ varying views regarding 

these issues. Therefore, CBOE has asked 

the Commission to impose uniform 

rules and enforcement standards that 

would apply in this area. In particular, 

CBOE recommends that the Commission 

take action to ensure that ‘‘options 

exchanges’ rules allow an executing 

broker to participate with some portion 

of its customer’s order only if [the] order 

has been exposed first to the market in 

a manner that provides a meaningful 

opportunity for price improvement.’’ 101

Question 29. Should the Commission 

take action, as CBOE recommends, to 

prohibit a broker from internalizing all 

or part of its customers’ orders if those 

orders have not first been exposed to the 

market in a manner that provides what 

CBOE terms ‘‘a meaningful 

opportunity’’ for price improvement? 

What would constitute ‘‘a meaningful 

opportunity’’ for price improvement? 102

Question 30. Do the options 

exchanges’ current rules requiring that 

an order first be exposed to an auction 

before a firm can internalize it provide 

a meaningful opportunity for price 

improvement? 

Question 31. What improvements 

could be made to the current framework 

for cross-market surveillance in the 

options markets to improve the ability 

of SROs to bring a best execution case 

against a broker that presents an order 

to be facilitated on one market and 

cancels that order, later executing it at 

an inferior price on another market?

Question 32. Are there other 

practices, occurring frequently with 

respect to facilitation guarantees that are 

inconsistent with best execution 

obligations? For example, are there 

circumstances under which an upstairs 

firm should not be permitted to ‘‘shop’’

an order it is seeking to facilitate at 

more than one exchange to determine 

where it can get the most favorable 

terms for that order? 

Question 33. Are the options 

exchanges’ rules with respect to 

facilitation guarantees (and the 

application of those rules) consistent 

regarding which conduct should and 

should not be permitted? 

F. Should the Commission Apply Rule 

11Ac1–5 to Options? 

In 2000, when the Commission 

deferred applying Rule 11Ac1–5 to 

Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 6137

103For example, Rule 11Ac1–5 requires market 

centers to disseminate for market orders and 

marketable limit orders the average effective spread 

for executions of orders covered by the rule. The 

‘‘average effective spread’’ is the share-weighted 

average of effective spreads for order executions 

calculated, for buy orders, as double the amount of 

difference between the execution price and the 

midpoint of the consolidated best bid and offer at 

the time of order receipt. See Rule 11Ac1–5 (a)(2).

104See supra note 72 and accompanying text.

105 17 CFR 240.11Ac1–4.

106NASD found that, as a result of the Limit 

Order Display Rule and other market structure 

changes implemented at the time, quoted spreads 

in the securities NASD studied declined, on 

average, by forty-one percent. Effective spreads 

declined, on average, by twenty-four percent. See

NASD Economic Research, Market Quality 

Monitoring: Overview of 1997 Market Changes 

(March 17, 1998).

107 17 CFR 240.11Ac1–4(b). In the alternative, the 

specialist or market maker may, among other things, 

immediately execute the limit order or route it to 

another market center that will display it. 17 CFR 

240.11Ac1–4(c).

108See, e.g., Exchange Act Release Nos. 43126 

(August 7, 2000), 65 FR 49621 (August 14, 2000) 

(seeking public comment on File No. SR–Phlx–00–

34) and 43550 (Nov. 13, 2000), 65 FR 69979 (Nov. 

21, 2000) (seeking public comment on File No. SR–

PCX–00–15). See also File No. SR–Amex–00–27.

options, it noted ‘‘potentially difficult 

issues would have to be addressed 

before options could be included within 

Rule 11Ac1–5.’’ These issues include 

the creation of an NBBO for the options 

markets and the practical problem of the 

categorization of orders on a securityby-security basis, given that there may 

be hundreds of series of options for each 

underlying equity security. The 

Commission continues to believe that 

execution quality information benefits 

investors and other market participants 

in determining which markets offer the 

type of execution that they value. 

As discussed above, OPRA has begun 

offering vendors an NBBO for the 

options markets, thereby removing one 

of the key obstacles to extending Rule 

11Ac1–5 to options. Although the OPRA 

NBBO is somewhat limited in that it 

does not reflect price changes of less 

than $0.05 or update size changes of 

fewer than 10 contracts (in the absence 

of a price change), it would appear to 

provide options exchanges with a 

standardized NBBO that would permit 

them to make the calculations required 

by Rule 11Ac1–5.103

Question 34. Would Rule 11Ac1–5 

data be useful to firms routing 

customers’ options orders to exchanges 

and to those customers? 

Question 35. If Rule 11Ac1–5 data 

would be useful for options orders, what 

adjustments, if any, would options 

market centers need to make to calculate 

and disseminate Rule 11Ac1–5 

statistics? For example, is the OPRA 

NBBO a sufficient measure to enable 

market centers to make the Rule 11Ac1–

5 calculations that require a 

consolidated BBO? If not, what changes 

would need to be made to the OPRA 

NBBO to make it suitable for such 

calculations? 

Question 36. Are there other reasons 

why Rule 11Ac1–5 should not be 

applied to the options markets? For 

example, do the anticipated benefits of 

having better execution quality 

information for the respective options 

market centers justify the costs that the 

market centers would incur in 

calculating and disseminating the Rule 

11Ac1–5 statistics? 

G. Would Penny Quotes in Options 

Reduce Payment for Order Flow? 

The Commission believes that an 

argument can be made that payment for 

order flow may be a symptom of a 

broader problem of an inefficient market 

that can be rectified only by better 

aligning the quoting increments of the 

options markets with those of the 

equities markets. With few exceptions, 

the U.S. equities markets quote in 

minimum increments of one cent, while 

the options markets continue to quote in 

ten-cent increments for options priced 

$3.00 and over and five-cent increments 

for options priced under $3.00. As 

discussed above, research with respect 

to equity securities has indicated that 

the move to penny increments has 

greatly reduced spreads in equities,104

which, in turn, appears to have played 

a role, at least in the short-term, in 

reducing payment for order flow. The 

same result could occur with respect to 

options if the minimum pricing 

increment decreased to one cent.

Question 37. If options were quoted in 

penny increments, would payment for 

order flow in the options markets cease 

or be diminished? 

Question 38. Would a move to penny 

quoting in the options markets place an 

undue strain on existing system 

capacity? If so, which market 

participants would be most negatively 

impacted (e.g., broker-dealers, 

exchanges, vendors)? 

Question 39. If so, are there ways to 

alleviate potential strains on system 

capacity to allow the options markets to 

begin quoting in penny increments? 

Question 40. Are there other issues 

that make a move to penny quoting in 

the options markets infeasible or 

inadvisable? For example, what would 

be the impact on the rapidity of quote 

changes (i.e., ‘‘flickering quotes’’)? 

Question 41. If exchanges required 

brokers to pay directly for the capacity 

that they use, would the brokers quote 

more efficiently, and thereby make a 

move to penny pricing in the options 

markets more feasible?

H. Should the Commission Apply the 

Limit Order Display Rule to Options? 

As discussed above, in December 

2000, the Commission extended the 

Quote Rule to the options markets. 

Exchange Act Rule 11Ac1–4 (‘‘Limit 

Order Display Rule’’),105 a rule that 

complements the Quote Rule and that is 

in place in the equities markets, does 

not currently apply to options. 

Adoption of the Limit Order Display 

Rule, as well as other order handling 

rules, in the equity markets dramatically 

narrowed spreads as customer limit 

orders began to compete with the quotes 

of market professionals to set the best 

prices in the market.106

With certain exceptions, Rule 11Ac1–

4 requires, among other things, that 

specialists and over-the-counter market 

makers immediately publish customer 

limit orders that improve the specialist’s 

or market maker’s quote in a particular 

security.107 While certain of the options 

exchanges have proposed rules that 

would require the immediate display of 

customer limit orders,108 currently there 

is no uniform limit order display 

requirement that applies across the 

options markets. Nevertheless, the 

increase in intramarket competition 

brought about by certain of the market 

structure changes discussed above could 

suggest that a uniform limit order 

display rule should apply to the options 

markets.

Question 42. Should the Commission 

apply a limit order display obligation to 

the options markets? 

Question 43. Would the benefits of a 

uniform display requirement justify the 

costs of imposing such an obligation on 

options market participants? 

Question 44. Do the options markets 

have unique characteristics that would 

make the application of a uniform limit 

order display obligation there less 

feasible than in the equities markets? If 

so, what are those characteristics? 

Question 45. If a limit order display 

obligation would be beneficial for the 

options markets, what modifications, if 

any, to Rule 11Ac1–4, would be 

required before it could be applied to 

options market participants? 

Question 46. If a uniform limit order 

display requirement is not appropriate 

for the options markets, are there other 

safeguards that could be put in place to 

ensure that customer limit orders are 

immediately displayed? 

6138 Federal Register / Vol. 69, No. 26 / Monday, February 9, 2004 / Proposed Rules 

VII. Solicitation of Additional 

Comments 

In addition to the areas for comment 

identified above, we are interested in 

any other issues that commenters may 

wish to address relating to the options 

markets. Please be as specific as 

possible in your discussion and analysis 

of any additional issues. Where 

possible, please provide empirical data 

or observations of market trends to 

support or illustrate your comments.

By the Commission. 

Dated: February 3, 2004. 

Margaret H. McFarland, 

Deputy Secretary.

[FR Doc. 04–2646 Filed 2–6–04; 8:45 am] 

BILLING CODE 8010–01–P