From: Andrew W. Lo [alo@MIT.EDU] Sent: Saturday, February 15, 2003 11:37 PM To: rule-comments@sec.gov Subject: SR-BSE-2002-15 Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 5th St., NW Washington, DC 20549 Dear Mr. Katz, I am writing in support of the Boston Stock Exchange's proposal to establish a new electronic market for equity options called the Boston Options Exchange (BOX). I lend my support to this initiative from three different perspectives. As a governor of the Boston Stock Exchange, I have been involved in vetting this initiative along with the other governors and am confident that the proposed rules of the new exchange will make BOX an innovatiive addition to existing financial markets. As a founder and the chief scientific officer of AlphaSimplex Group, LLC, a quantitative investment management company, I am enthusiastic about any innovation that leads to better executions, more liquidity, and a higher degree of automation in the trading process, all of which are promised by BOX. And finally, as a professor f finance at MIT's Sloan School of Management, I have a strong conviction that financial innovation is one of the most enduring strengths of the US financial system, and BOX is part of the natural evolution of financial markets towards greater efficiency, transparency, and liquidity. Since you must have already received many comment letters focusing on the specific aspects of the proposed rules of BOX, I will not repeat the obvious arguments in support of those rules---I believe it is almost self-evident that the proposed structure is intended to enhance competition, allow fair and open access, and encourage liquidity in this electronic market. Instead, I would like to focus on the broader issue of whether or not we really need another options exchange in light of existing markets. In particular, many critics will no doubt raise the issue of "fragmentation" in challenging the wisdom of BOX. Some might argue that introducing another exchange seems to be at odds with the very reason for having an exchange: consolidating order flow to enhance liquidity. However, the Commission's own Rule 19c-3 is clear recognition that consolidation can sometimes work against the interest of investors, and that the benefits of multiple venues and increased competition for trading securities can outweigh the efficiency gains of consolidation and the potential costs of restraining free trade. Now there have been many academic studies, both theoretical and empirical, on the costs and benefits of consolidation vs. fragmentation, and the bottom line is that this is an extremely difficult issue and there are no clearcut answers. Indeed, you are likely to find equally compelling studies on both sides of the issue. The reason for this unsettling state of affairs is the fact that our mathematical models of financial markets are highly stylized and simplistic, and capture only a small part of the complexity of market dynamics. Therefore, depending on the specific assumptions used in a given model, or the particular parametrization adopted by an empirical study, one can reach almost any conclusion desired regarding the pluses and minuses of consolidation. As an admitted practitioner of the black art of financial modeling, I would like to propose another perspective that I think may be more productive. An alternative paradigm is to view financial markets as an evolving set of social norms, conventions, and institutions, with the ultimate, if undirected, goal of allowing individuals to allocate capital and risk more effectively. In this rather unconventional paradigm---an ecological perspective, not so much an economic one---financial innovation is not necessarily the outcome of rational decisionmaking on the part of economic agents, but rather an organic process driven by perceived business opportunities on the part of entrepreneurs and investors. In such a context, allowing more innovation---the equivalent ecological notion is "biodiversity", or the presence of many different species---is critical to the long-term health and welfare of the financial system. Whether or not BOX is the "right" market structure is virtually impossible to say given our existing tools of financial analysis, but it is clear that financial innovation should be fostered and encouraged so as to promote the general health and robustness of our capital markets. A recent analogy might help to illustrate this principle of economic diversity. A few years ago, a number of entities called "electronic communications networks" (ECNs) sprung into existence, apparently in response to some significant unfulfilled needs on the part of investors for more efficient methods for trading US equities. Thanks to SEC no-action letters, ECNs proliferated for some time, leading to many important technological breakthroughs in equity execution, crossing, and order processing. After this great burst of new business development (which is reminiscent of the theory of "punctuated equilibria" in evolutionary biology), we are now experiencing a phase of consolidation where the many ECNs are being re-organized into a smaller number of more efficient business entities. The lesson to be drawn from this experience is that it is almost impossible to predict the viability and ultimate desirability of any single business venture or market structure, but if innovation is actively fostered and supported, market forces will likely shape the direction of new structures to the benefit of investors. Returning to the case of ECNs, it is now an indisputable fact that ECNs have greatly enhanced market liquidity, and investors are clearly better off, yet it would have been impossible to mandate the specific institutional structures and business partnerships that now characterize the equity-trading landscape. In the same way that equity trading has undergone a dramatic transformation over the past decade thanks to economic, technological and regulatory breakthroughs, it is my hope and expectation that BOX will be part of a similar transformation in the equity derivatives markets. Therefore, I strongly urge the Commission to support the BOX initiative and approve the proposed rules as filed. Thank you for your time and consideration in reviewing this comment letter. Sincerely, Andrew W. Lo Harris & Harris Group Professor of Finance Chief Scientific Officer Director, MIT Laboratory for Financial Engineering AlphaSimplex Group, LLC MIT Sloan School of Management One Cambridge Center 50 Memorial Drive, E52-432 Cambridge, MA 02142 Cambridge, MA 02142