We received quite a bit of feedback from yesterday’s note on the directed options order proposal that Nasdaq BX just received a disapproval for from the SEC . Many of you expressed outrage that an exchange would try to propose a rule which would clearly hurt customer orders.   We want to expand on that note today specifically by focusing on the comments that NYSE Euronext made against the BX proposal.  We want to focus on these comment letters because they are a good example of what needs to be done in order to get a rule change disapproved.

To refresh your memory, here was the BX proposal:

“BX proposes to establish a directed order process that would permit members of BX to direct orders in listed options to a particular market maker on BX.  As detailed below, a Directed Market Maker would be eligible to receive an allocated percentage of the Directed Order (40%) at all price levels at which the Directed Market Maker has a quote or order. To receive a Directed Allocation, the Directed Market Maker would be required to have quotes or orders at the National Best Bid or National Best Offer (“NBBO”) at the time of the execution of the Directed Order; the Directed Market Maker would not be required to be quoting at the NBBO at the time the Directed Order is received.” 

In their first comment letter  dated April 2, 2013 on the proposal, NYSE voiced concerns over internalization and price improvement. They were concerned that BX would be giving out unfair trade allocations andthe level of internalization would increase:

“This is an unprecedented development and one regarding which NYSE Euronext has serious concerns…Removal of sufficient order flow via 100% internalization will reduce trading opportunities for other participants. Such a reduction in the opportunity to trade at the NBBO is detrimental to investors and the NMS system as a whole.”

In their second comment letter  dated May 10, 2013, NYSE strengthened their case against the BX proposal:

“The BX Proposal would (1) disincentivize the public price discovery process because it permits market makers to obtain priority while quoting away from the NBBO and (2) permit Directed Allocations to a market maker that enters a quote after a public customer order eligible to trade with a subsequent Directed Order. Both of these issues are inconsistent with the purposes of the Exchange Act.”

“NYSE Euronext believes the BX Proposal would inhibit the public price discovery process and lessen the incentive to publicly display orders. Even more concerning, the Proposal would put public customers at a disadvantage to sophisticated market makers.”

In a third comment letter , NYSE blasted BX for failing to adequately respond to their concerns and turned up the heat on their concerns:

“NYSE believes that BX has failed to address properly the concerns raised by NYSE’s comment letters and reflected in the Commission’s Order Instituting Proceedings and therefore believes that the Commission should disapprove the BX Proposal.”

“The BX Proposal is likely to move options liquidity to prices that are inferior for investors (but preferable for market makers quoting at prices inferior to the original NBBO).”

We often read through exchange proposals and its very rare the any of them receive comments.  It’s even rarer that you will see three comment letters from the same commenter.  By consistently following up with the SEC on their concerns, NYSE made sure that the SEC did their homework.  Effectively, NYSE’s comments forced the SEC to put away their rubber stamps.

NYSE’s comments prove that the comment letter system works.  The SEC reads all of the comment letters and takes them into account when approving or rejecting a rule proposal. We got lucky this time that NYSE was so vocal.  But how many other proposals have slipped beneath the radar because nobody took the time to comment?  We are going to try as a firm to submit more comment letters and we hope that you will consider doing the same.