Self-Regulatory Organizations; NYSE MKT LLC; Order Disapproving a Proposed Rule Change To Modify the NYSE Amex Options Fee Schedule With Respect to Fees, Rebates, and Credits for Transactions in the Customer Best Execution Auction

I. Introduction

On April 11, 2016, NYSE MKT LLC (the “Exchange” or “NYSE MKT”) filed with the Securities and Exchange Commission (the “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (the “Act”), and Rule 19b-4 thereunder, a proposed rule change (File No. SR-NYSEMKT-2016-45) to modify the NYSE Amex Options Fee Schedule with respect to fees, rebates, and credits relating to the Exchange's Customer Best Execution Auction (“CUBE Auction”), and to increase credits available under the Exchange's Amex Customer Engagement Program (“ACE Program”). The proposed rule change was immediately effective upon filing with the Commission pursuant to Section 19(b)(3)(A) of the Act. Notice of filing of the proposed rule change was published in the Federal Register on April 26, 2016. On June 9, 2016, the Commission temporarily suspended the Exchange's proposal and simultaneously instituted proceedings to determine whether to approve or disapprove the proposed rule change. The Commission thereafter received ten comment letters on the proposal, one of which was from the Exchange. This order disapproves the proposed rule change.

II. Description of the Proposed Rule Change

The Exchange's proposal amended certain fees, rebates, and credits relating to executions through its CUBE Auction. First, the proposal increased the fees assessed by the Exchange for RFR Responses (i.e., orders and quotes submitted during a CUBE Auction that are executed against the agency order). Specifically, the Exchange increased RFR Response fees for Non-Customers (including market makers) from $0.12 to $0.70 for classes subject to the Penny Pilot (“Penny classes”) and from $0.12 to $1.05 for classes not subject to the Penny Pilot (“Non-Penny classes”).

Further, the proposal increased a rebate available to Initiating Participants in CUBE Auctions (i.e., ATP Holders that initiate such auctions) under the Exchange's ACE Program. Specifically, the proposal increased the rebate paid to Initiating Participants that meet certain tiers of the ACE Program from $0.05 to $0.18 (the “ACE Initiating Participant Rebate”) for each of the first 5,000 Customer contracts of an agency order executed in a CUBE Auction.

Finally, the proposal increased the credit paid by the Exchange to Initiating Participants (the “break-up credit”) for each contract in the contra-side order that is paired with the agency order that does not trade with the agency order because it is replaced in the auction. Prior to the proposal, the credit granted was $0.05 per contract in all classes. The proposal raised it to $0.35 for Penny classes and $0.70 for Non-Penny classes.

The amended fees resulted in a proposed difference between the fees charged to an Initiating Participant and those charged to Non-Customer auction responders that would be a minimum of $0.65 in Penny classes and $1.00 in Non-Penny classes. Taking into consideration that the ACE rebate available to an Initiating Participant submitting the agency order into the CUBE Auction was increased to $0.18, this proposed fee differential could be as high as $0.83 per executed contract for Penny classes, and $1.18 per contract for Non-Penny classes.

In its filing, the Exchange stated that the changes to the CUBE Auction transaction fees are reasonable, equitable and not unfairly discriminatory “because they apply equally to all ATP Holders that choose to participate in the CUBE, and access to the Exchange is offered on terms that are not unfairly discriminatory.” The Exchange also took the position, with regard specifically to the ACE Initiating Participant Credit, that the change is reasonable, equitable, and not unfairly discriminatory because it is “designed to attract more volume and liquidity to the Exchange generally, and to CUBE Auctions specifically,” which, according to the Exchange, “would benefit all market participants . . . through increased opportunities to trade at potentially improved prices as well as enhancing price discovery.” The Exchange stated that its proposal is reasonable because it is similar to the fee and credit structures previously applied to the CUBE Auction and to fees charged for similar auctions on other exchanges. The Exchange further stated that the proposal “would improve the Exchange's overall competitiveness and strengthen its market quality for all market participants.” Finally, the Exchange stated that it did not believe the proposal would impose any unnecessary or inappropriate burden on competition because it is “pro-competitive” and “designed to incent increases in the number of CUBE Auctions brought to the Exchange,” thereby “benefit[ting] all Exchange participants through increased opportunities to trade as well as enhancing price discovery.”

III. Order Instituting Proceedings and Comments Received

In the Order Instituting Proceedings, the Commission stated that it would further assess whether the proposal satisfies the statutory provisions that require exchange rules to: (1) provide for the equitable allocation of reasonable fees among members, issuers, and other persons using its facilities; (2) be designed to perfect the mechanism of a free and open market and a national market system and to protect investors and the public interest, and not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers; and (3) not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Act.

In the Order Instituting Proceedings, the Commission expressed concern about the potential effect the proposal could have on the operation of the CUBE Auction and its potential to provide price improvement to customers, as well as about its effect upon competition among participants initiating CUBE Auctions and those responding to them. The Commission acknowledged that increasing the rebates and break-up credits provided to Initiating Participants likely would strengthen their incentive to bring customer orders to the Exchange. However, the Commission also noted that substantially increasing the fees paid by Non-Customer auction responders could deter them from participating in CUBE Auctions. The Commission observed that in Penny classes, for example, the fee charged Non-Customer auction responders would exceed one-half the minimum trading increment, and the economic differential between such auction responders and the Initiating Participants with whom they are competing would be even more.

Further, in the Order Instituting Proceedings, the Commission raised questions as to whether the proposal would in fact provide the additional trading opportunities for Non-Customer auction responders and other market quality benefits suggested by the Exchange. The Commission noted that the Exchange did not address the fact that the proposal would substantially increase the difference in the fees assessed by the Exchange on Initiating Participants and Non-Customer auction responders, and indicated that substantially exacerbating the differences in the fees assessed by the Exchange on Initiating Participants and those assessed on Non-Customer auction responders raises issues as to whether the proposal is equitable and not unfairly discriminatory among Exchange members. The Commission also noted in the Order Instituting Proceedings that the Exchange did not support with specific reasoning or data its statement that the proposal would provide all members additional trading opportunities and other market quality benefits. The Commission further stated that the Exchange did not sufficiently address the potential burden that its proposed fee changes would have on competition between Initiating Participants and Non-Customer auction responders, or the prospect that competition in CUBE Auctions could be impaired, by substantially increasing the auction response fees paid by Non-Customer auction responders. Moreover, the Commission noted that the Exchange did not address in any detail the increases in the break-up credit payable to an Initiating Participant for each contract in a CUBE Order that is executed by others, and why the proposed increase in this payment is reasonable, equitable, and not unfairly discriminatory.

The Commission received ten comment letters in response to the Order Instituting Proceedings, one of which was from the Exchange. The nine commenters other than the Exchange either specifically recommended that the Commission disapprove the Exchange's proposal or expressed concerns about the proposal in its current form. Broadly, these commenters echoed many of the concerns, summarized above, that were raised by the Commission in the Order Instituting Proceedings. Among other things, commenters focused on the potential impact of the proposed raising of fees for Non-Customer auction responders, increases in rebates to Initiating Participants, and heightened differential in the costs between Non-Customer auction responders and Initiating Participants, that would result from the proposal. They also questioned the level of auction response fees generally, the consequences of break-up credits, and the potential effect of the proposal on the quoting behavior of market makers.

More specifically, many commenters believed that the fee differentials created by the Exchange's proposal would significantly favor Initiating Participants over Non-Customer auction responders. Some commenters highlighted the fact that the proposed increase in fees assessed on Non-Customer auction responders, without any change to the Initiating Participant fees, would widen the differential between these two groups of participants. Several commenters acknowledged that the Exchange's auction fee structure was not unique in providing for differentials, but emphasized their belief that the Exchange's proposal would further and unacceptably exacerbate a trend of raising auction response fees and widening differentials. To the extent that the proposal would further increase these fees and widen the disparity in fees assessed on the different participants, these commenters believed that the proposal was inequitable, unfairly discriminatory, and unreasonably burdensome on competition.

A few commenters stated that an effect of the proposed fees would be to limit opportunities for price improvement in the CUBE mechanism by discouraging auction responders from effectively participating. One of these commenters further argued that the diminished competition would encourage Initiating Participants to submit less competitive prices to begin an auction. Two commenters took the position that it was unfairly discriminatory to increase fees for Non-Customer auction responders while correspondingly increasing rebates to Initiating Participants. One of these commenters further suggested that the Commission impose a maximum fee differential of $0.02 between Initiating Participants and non-Initiating Participants.

Commenters expressed other concerns as well. One commenter stated that high response fees generally disincentivize firms from responding to an auction and offering price improvement. Another commenter argued that auction response fees are comparable to access fees charged by exchanges and should be limited more generally. Two commenters supported limiting auction response fees in both Penny and Non-Penny classes to no more than half the minimum trading increment. Another commenter similarly supported a cap on auction response fees, but stated that the amount should be set at a much lower level than half the minimum increment in the Penny classes. Still another commenter stated that an absolute cap would not be necessary. Instead, this commenter maintained, the Commission should prohibit fee differentials between market participants, reasoning that, if exchanges were barred from discriminating between participant types, competitive market forces would lower the absolute fee levels to a reasonable amount. In addition, five commenters expressed specific concern about break-up credits, contending that they are per se unfairly discriminatory in that they provide a benefit solely to Initiating Participants and thereby discourage competition and limit price improvement.

Several commenters expressed concern that high transaction fees in auction mechanisms generally, not only the fees under the Exchange's proposal, could harm options market quality by negatively impacting market maker quoting behavior. A few commenters believed that high auction response fees, such as those proposed by the Exchange, would discourage quoting in the options markets because they would encourage increased internalization in the auctions. One of these commenters stated that market makers would respond to the proposed fees by reducing the number, size, and quality of their displayed quotations. Another commenter believed that this would diminish the degree of actual price improvement provided by the auctions, because, while auction executions will occur at or better than the NBBO, this NBBO may have been better at the outset if not for the negative effects of the high auction fees. One commenter contended that increased transaction fees in general, and especially disproportionate fees among various market participants, will lead to overall decreased competition and liquidity in the options market. In addition, several commenters expressed concerns that break-up fees, break-up credits, auto-match functionality, and the ability to initiate an auction at the NBBO are all among features of auctions that may incentivize internalization, decrease competition, and impair market quality. Finally, commenters broadly suggested that the Commission conduct a holistic review of options exchange electronic auction mechanisms.

In its comment letter, the Exchange broadly expressed concerns with options exchange electronic auction mechanisms, and stated its belief that such mechanisms should guarantee price improvement. However, the Exchange did not provide additional justification for the proposal, or respond specifically to the concerns expressed in the Order Instituting Proceedings. Rather, the Exchange stated that its proposal was developed in response to competitive concerns and that the suspension placed it at a competitive disadvantage compared to other exchanges with comparable fees that were unaffected by the Order Instituting Proceedings. The Exchange requested that the Commission end its temporary suspension of the proposal while the Commission undertakes a broad review of the fee structures applied by the options exchanges to their price improvement auctions.

IV. Discussion and Commission Findings

Under Section 19(b)(2)(C) of the Act, the Commission shall approve a proposed rule change of a self-regulatory organization if it finds that such proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder that are applicable to such organization. The Commission shall disapprove a proposed rule change if it does not make such a finding. Rule 700(b)(3) of the Commission's Rules of Practice states that the “burden to demonstrate that a proposed rule change is consistent with the Exchange Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change” and that a “mere assertion that the proposed rule change is consistent with those requirements . . . is not sufficient.”

In the Order Instituting Proceedings, the Commission raised concerns about the effect the proposal could have on the operation of the CUBE Auction and its ability to provide price improvement to customers, as well as the impact it could have on competition among participants initiating CUBE Auctions and those responding to them. The Commission pointed to several specific elements of the proposal for which, in its view, the Exchange had not provided sufficient justification to enable the Commission to find that the proposal was consistent with the Act. In particular, the Commission noted that the Exchange justified the proposal on the grounds that it would create incentives for Initiating Participants to bring customer orders to the Exchange, and thereby benefit all members by providing more trading opportunities, potential price improvement, tighter spreads, and enhanced market quality. The Commission acknowledged that increasing the rebates and break-up credits provided to Initiating Participants likely would strengthen their incentives to bring customer orders to the Exchange, but expressed concern that substantially increasing the fees paid by Non-Customer auction responders could deter them from participating in CUBE Auctions. The Commission further noted that the proposal would substantially exacerbate the differences in the fees assessed by the Exchange on Non-Customer auction responders as compared to those for Initiating Participants. The Commission stated that in Penny classes, for example, the fee charged Non-Customer auction responders would exceed one-half the minimum trading increment, and the economic differential between Non-Customer auction responders and the Initiating Participants with whom they are competing would be even more. Accordingly, the Commission believed that questions were raised as to whether the proposal would in fact provide the additional trading opportunities for non-Initiating Participants and other market quality benefits suggested by the Exchange.

As discussed above, most commenters broadly echoed the Commission's concerns, and several expressed the view that the proposal would not provide the additional trading opportunities for non-Initiating Participants and other market quality benefits suggested by the Exchange. Specifically, several commenters stated that an effect of the proposed fees would be to limit opportunities for price improvement in the CUBE mechanism by discouraging auction responders from effectively participating, and expressed concern that the fee structure in auction mechanisms could harm options market quality by negatively impacting market maker quoting behavior. In addition, commenters were concerned that the proposed fees would widen the cost differential between Non-Customer auction responders and Initiating Participants such that the differential would be excessive as compared with those of other options exchanges.

In its comment letter, the Exchange did not respond specifically to the concerns articulated in the Order Instituting Proceedings or in the comments, or otherwise offer any additional information to support its view that the proposal would provide additional trading opportunities for non-Initiating Participants and other market quality benefits. The Exchange simply characterized its proposal as a competitive response to certain other options exchanges, two of which had been charging auction response fees in Penny classes in excess of $0.50 per contract. The Commission notes that, in the interim, both such exchanges have reduced their auction response fees (inclusive of marketing fees) so that they no longer exceed half the minimum trading increment in Penny classes.

As noted, Rule 700(b)(3) of the Commission's Rules of Practice states that the “burden to demonstrate that a proposed rule change is consistent with the Exchange Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change” and that a “mere assertion that the proposed rule change is consistent with those requirements . . . is not sufficient.” The Exchange has taken the position that its proposal meets applicable Exchange Act standards, including that fees be reasonable, equitably allocated, and not unfairly discriminatory, and that they not impose any unnecessary or inappropriate burden on competition, on the grounds that the proposed fee changes would benefit all market participants through increased trading opportunities and improved market quality. Although the Commission expressed concern, in the Order Instituting Proceedings, that the reasoning behind this assertion was not clear and no supporting data had been provided, the Exchange has offered no additional justification or evidence to support this key aspect of its statutory basis.

Accordingly, after careful consideration, the Commission does not find that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. In particular, the Commission does not find that the proposed rule change is consistent with: (1) Section 6(b)(4) of the Act, which requires that the rules of a national securities exchange provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities; (2) Section 6(b)(5) of the Act, which requires that the rules of a national securities exchange be designed, among other things, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest, and not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers; and (3) Section 6(b)(8) of the Act, which requires that the rules of a national securities exchange do not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Act. Because any of these determinations under the Act independently necessitates disapproving the proposal, the Commission does so.

V. Conclusion

For the reasons set forth above, the Commission does not find that the proposed rule change is consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange, and in particular, Sections 6(b)(4), 6(b)(5), and 6(b)(8) of the Act.

It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-NYSEMKT-2016-45) be, and hereby is, disapproved.