Self-Regulatory Organizations; Proposed Rule Changes:

Federal Register Volume 76, Number 190 (Friday, September 30, 2011)

Notices

Pages 60955-60957

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

FR Doc No: 2011-25193

SECURITIES AND EXCHANGE COMMISSION

Release No. 34-65399; File No. SR-Phlx-2011-111

Self-Regulatory Organizations; NASDAQ OMX PHLX LLC; Order

Approving a Proposed Rule Change Requesting Permanent Approval of the

Pilot Program Permitting NASDAQ OMX PHLX to Receive Inbound Routes by

NOS

September 26, 2011.

  1. Introduction

    On August 8, 2011, NASDAQ OMX PHLX LLC (``Phlx'' or ``Exchange'') filed with the Securities and Exchange Commission (``Commission''), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

    (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change requesting permanent approval of the Exchange's pilot program to permit the Exchange to accept certain inbound orders that Nasdaq Options

    Services, LLC (``NOS'') routes from Nasdaq Options Market (``NOM'').

    The proposed rule change was published for comment in the Federal

    Register on August 19, 2011.\3\ The Commission received no comment letters regarding the proposed rule change. This order approves the proposed rule change.

    \1\ 15 U.S.C. 78s(b)(1).

    \2\ 17 CFR 240.19b-4.

    \3\ See Securities Exchange Act Release No. 65135 (August 15, 2011), 76 FR 52030 (``Notice'').

  2. Background

    Exchange Rule 985(b) prohibits the Exchange or any entity with which it is affiliated from, directly or indirectly, acquiring or maintaining an ownership interest in, or engaging in a business venture with, an Exchange member or an affiliate of an Exchange member in the absence of an effective filing under Section 19(b) of the Exchange

    Act.\4\ NOS is a broker-dealer that is a member of the Exchange, and currently provides to members of The NASDAQ Stock Market LLC

    (``Nasdaq'') that are NOM participants optional routing services to other market centers.\5\ NOS is owned by The NASDAQ OMX Group, Inc.

    (``NASDAQ OMX''), which also owns three registered securities exchanges--Nasdaq, the Exchange, and NASDAQ OMX BX, Inc.\6\ Thus, NOS is an affiliate of each of these exchanges. Absent an effective filing,

    Exchange Rule 985(b) would prohibit NOS from being a member of the

    Exchange.

    \4\ 15 U.S.C. 78s(b).

    \5\ NOS operates as a facility of Nasdaq that provides outbound routing from NOM to other market centers, subject to certain conditions. See NOM Rules Chapter VI, Section 11(e).

    \6\ See Securities Exchange Act Release No. 58179 (July 17, 2008), 73 FR 42874 (July 23, 2008) (SR-Phlx-2008-31) (``Phlx

    Approval Order''). See also Securities Exchange Act Release No. 58324 (August 7, 2008), 73 FR 46936 (August 12, 2008) (SR-BSE-2008- 02; SR-BSE-2008-23; SR-BSE-2008-25; SR-BSECC-2008-01).

    On July 17, 2008, in connection with the acquisition of the

    Exchange by NASDAQ OMX, the Commission approved an affiliation between the Exchange and NOS for the limited purpose of permitting NOS to provide routing services for Nasdaq for orders that first attempt to access liquidity on Nasdaq's system before routing to the Exchange, subject to certain other limitations and conditions.\7\ On February 26, 2010, the Exchange filed an immediately effective proposed rule change to modify the conditions for the affiliation between NOS and the

    Exchange, to permit the Exchange to receive certain orders routed by

    NOS from NOM without first checking the NOM book for liquidity on a one-year pilot basis.\8\ Specifically, the Exchange proposed to permit

    NOS to route from NOM Exchange Direct Orders and orders in NOM Non-

    System Securities (including Exchange Direct Orders).\9\

    Page 60956

    The Exchange now seeks permanent approval of this inbound routing pilot.\10\

    \7\ See Phlx Approval Order, 73 FR at 42887.

    \8\ See Securities Exchange Act Release No. 61667 (March 5, 2010), 75 FR 11964 (March 12, 2010) (SR-Phlx-2010-36) (``Phlx

    Routing Pilot Release''). The inbound routing pilot was subsequently extended and is set to expire on November 25, 2011. See Securities

    Exchange Act Release Nos. 63873 (February 9, 2011), 76 FR 8798

    (February 15, 2011) (SR-Phlx-2011-16); and 65140 (August 16, 2011) 76 FR 52374 (August 22, 2011) (SR-Phlx-2011-116).

    \9\ NOS provides to NOM participants routing services to other market centers. Pursuant to Nasdaq's rules, NOS: (1) Routes orders in options currently trading on NOM, referred to as ``System

    Securities;'' and (2) routes orders in options that are not currently trading on NOM (``Non-System Securities''). See NOM Rules,

    Chapter VI, Section 1(b) and 11. When routing Non-System Securities,

    NOS is not regulated as a facility of Nasdaq, but as a broker-dealer regulated by its designated examining authority. See also Phlx

    Routing Pilot Release, 75 FR at 11964. ``Exchange Direct Orders'' are orders that are directed to an exchange other than NOM as directed by the entering party without checking the NOM book. See

    NOM Rules Chapter VI, Section 1(e)(7).

    \10\ See Notice.

  3. Discussion and Commission Findings

    After careful review, the Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.\11\ Specifically, the Commission finds that the proposed rule change is consistent with Section 6(b)(1) of the Act,\12\ which requires, among other things, that a national securities exchange be so organized and have the capacity to carry out the purposes of the Act, and to comply and enforce compliance by its members and persons associated with its members, with the provisions of the Act, the rules and regulation thereunder, and the rules of the Exchange. Further, the

    Commission finds that the proposed rule change is consistent with

    Section 6(b)(5) of the Act,\13\ which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices; to promote just and equitable principles of trade; to foster cooperation and coordination with persons engaged in regulating, clearing, settling, and processing information with respect to, and facilitating transactions in securities; 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. Section 6(b)(5) also requires that the rules of an exchange not be designed to permit unfair discrimination among customers, issuers, brokers, or dealers.

    \11\ In approving this proposed rule change, the Commission has considered the proposed rule's impact on efficiency, competition and capital formation. 15 U.S.C. 78c(f).

    \12\ 15 U.S.C. 78f(b)(1).

    \13\ 15 U.S.C. 78f(b)(5).

    Recognizing that the Commission has previously expressed concern regarding the potential for conflicts of interest in instances where a member firm is affiliated with an exchange of which it is a member, the

    Exchange previously proposed, and the Commission approved, limitations and conditions on NOS's affiliation with the Exchange.\14\ Also recognizing that the Commission has expressed concern regarding the potential for conflicts of interest in instances where a member firm is affiliated with an exchange to which it is routing orders, the Exchange previously implemented limitations and conditions to NOS's affiliation with the Exchange to permit the Exchange to accept orders routed inbound to Phlx by NOS from NOM that do not first attempt to access liquidity on the NOM book.\15\ The Exchange states it has met these conditions:\16\

    \14\ See Phlx Approval Order, 73 FR at 42886-42887.

    \15\ See Phlx Routing Pilot Release.

    \16\ See Notice, 76 FR at 52031.

    First, the Exchange and FINRA have entered into a regulatory services agreement (``Regulatory Contract'') pursuant to which FINRA has been allocated regulatory responsibilities to review

    NOS's compliance with the Exchange's rules through FINRA's examination program.\17\ The Exchange, however, retained ultimate responsibility for enforcing its rules with respect to NOS except to the extent that they are covered by an agreement with FINRA pursuant to Rule 17d-2 under the Act,\18\ in which case FINRA is allocated regulatory responsibility.

    \17\ The Exchange also states that NOS is subject to independent oversight by FINRA, its Designated Examining Authority, for compliance with financial responsibility requirements. See Notice, 76 FR at 52031, n.9.

    \18\ 17 CFR 240.17d-2.

    Second, FINRA and the Exchange will monitor NOS for compliance with Phlx's trading rules, and collect and maintain certain related information;\19\

    \19\ Pursuant to the Regulatory Contract, both the Exchange and

    FINRA will collect and maintain all alerts, complaints, investigations and enforcement actions in which NOS (in routing orders to the Exchange) is identified as a participant that has potentially violated applicable Commission or Exchange rules. The

    Exchange and FINRA will retain these records in an easily accessible manner in order to facilitate any potential review conducted by the

    Commission's Office of Compliance Inspections and Examinations. See

    Notice, 76 FR at 52031, n.11.

    Third, FINRA will provide a report to the Exchange's Chief

    Regulatory Officer (``CRO''), on at least a quarterly basis, that: (i)

    Quantifies all alerts (of which the Exchange and FINRA become aware) that identify NOS as a participant that has potentially violated

    Commission or Exchange rules and (ii) quantifies the number of investigations that identify NOS as a participant that has potentially violated Exchange or Commission Rules;\20\

    \20\ See id.

    Fourth, the Exchange adopted Rule 985(c), which requires

    NASDAQ OMX, as the holding company owning NOS and the Exchange, to establish and maintain procedures and internal controls reasonably designed to ensure that NOS does not develop or implement changes to its system on the basis of non-public information regarding planned changes to the Exchange's systems, obtained as a result of its affiliation with the Exchange, until such information is available generally to similarly situated Exchange members in connection with the provision of inbound routing to the Exchange; \21\ and

    \21\ See Phlx Rule 985(c)(1). See also Notice, 76 FR at 52031.

    Fifth, the Exchange proposed that NOS be authorized to route (1) Exchange Direct Orders without checking the NOM book and (2) orders in NOM non-system securities inbound to the Exchange from NOM for a pilot period of twelve months, as further extended to November 25, 2011.\22\

    \22\ See Notice, 76 FR at 52031. See also supra note 8.

    The Exchange believes that by meeting the above-listed conditions it has set up mechanisms that protect the independence of the Exchange's regulatory responsibility with respect to NOS, and has demonstrated that NOS cannot use any information advantage it may have because of its affiliation with the Exchange.\23\

    \23\ See Notice, 76 FR at 52031-52032.

    In the past, the Commission has expressed concern that the affiliation of an exchange with one of its members raises potential conflicts of interest, and the potential for unfair competitive advantage.\24\ Although the Commission continues to be concerned about potential unfair competition and conflicts of interest between an exchange's self-regulatory obligations and its commercial interest when the exchange is affiliated with one of its members, for the reasons discussed below, the Commission believes that it is consistent with the

    Act to permit NOS to provide inbound routing to the Exchange on a permanent basis instead of a pilot basis, subject to the other conditions described above.\25\

    \24\ See, e.g., Securities Exchange Act Release Nos. 54170 (July 18, 2006), 71 FR 42149 (July 25, 2006) (SR-NASDAQ-2006-006) (order approving Nasdaq's proposal to adopt Nasdaq Rule 2140, restricting affiliations between Nasdaq and its members); 53382 (February 27, 2006), 71 FR 11251 (March 6, 2006) (SR-NYSE-2005-77) (order approving the combination of the New York Stock Exchange, Inc. and

    Archipelago Holdings, Inc.); 58673 (September 29, 2008), 73 FR 57707

    (October 8, 2008) (SR-Amex-2008-62) (order approving the combination of NYSE Euronext and the American Stock Exchange LLC); 59135

    (December 22, 2008), 73 FR 79954 (December 30, 2008) (SR-ISE-2009- 85) (order approving the purchase by ISE Holdings of an ownership interest in DirectEdge Holdings LLC); and 59281 (January 22, 2009), 74 FR 5014 (January 28, 2009) (SR-NYSE-2008-120) (order approving a joint venture between NYSE and BIDS Holdings L.P.).

    \25\ The Commission notes that it recently issued an order granting permanent approval of NASDAQ OMX BX, Inc.'s pilot program permitting Boston Options Exchange to accept inbound routes by NOS of (1) NOM Exchange Direct Orders without checking the NOM book prior to routing, and (2) NOM non-system securities orders, including Exchange Direct Orders that NOS routes from NOM. See

    Securities Exchange Act Release No. 65199 (August 25, 2011), 76 FR 54277 (August 31, 2011) (SR-BX-2011-045).

    Page 60957

    The Exchange has proposed four ongoing conditions applicable to

    NOS's routing activities, which are enumerated above. The Commission believes that these conditions mitigate its concerns about potential conflicts of interest and unfair competitive advantage. In particular, the Commission believes that FINRA's oversight of NOS,\26\ combined with FINRA's monitoring of NOS's compliance with the Exchange's rules and quarterly reporting to Phlx's CRO, will help to protect the independence of the Exchange's regulatory responsibilities with respect to NOS.

    \26\ This oversight will be accomplished through the Regulatory

    Contract between the Exchange and FINRA, and, as applicable, a 17d-2

    Agreement.

  4. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the

    Act,\27\ that the proposed rule change (SR-Phlx-2011-111) be, and hereby is, approved.

    \27\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.\28\

    \28\ 17 CFR 200.30-3(a)(12).

    Elizabeth M. Murphy,

    Secretary.

    FR Doc. 2011-25193 Filed 9-29-11; 8:45 am

    BILLING CODE 8011-01-P

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