Speech by SEC Staff:
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect those of the Commission, the Commissioners or of the author's colleagues on the staff of the Commission.
I wanted to begin by thanking all of you for inviting me to participate once again in the Options Industry Conference. This conference is one of those that I look forward to each year, for several reasons. Notably, this conference seems to be held in the most appealing locations, and this year is clearly no different. And, fortunately, the options industry continues to evolve at break-neck speed, so that there never seems to be a lack of subject matter or controversy. With that in mind, please let me remind you once again that the views that I express are my own and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
Since I addressed this group last year, the options industry continues to innovate. The introduction of new classes of market makers on several of the options exchanges, who able to participate remotely from off the trading floor, have provided new opportunities for competition. Exchanges are also increasingly integrating their systems and expanding their use of technology so that most orders and quotes are entered and executed completely electronically. There has also been an increase in preferencing arrangements, as exchange rules permit order flow providers to direct their order flow to designated market makers to a greater extent.
Finally, exchanges are proposing a "next generation" of penny auctions. Several proposals currently filed with the Commission would permit the opportunity for options orders to obtain price improvement in pennies, without first attracting a sponsor willing to guarantee that improvement. These proposals are intended to provide a greater number of orders the opportunity to trade at prices better than the quote.
While the availability of trading opportunities in pennies is a step forward, the topic on many people's minds is quoting in pennies. What will be the effect of quoting in pennies on the options market? Will it change payment for order flow practices; perhaps eliminate them? What will be in the impact on execution quality? And, to what extent will penny quoting impact the quantity of pricing information disseminated to all market participants and what changes will be needed for exchange, broker-dealer, and vendor systems to handle it? Finally, in a marketplace with multiple, competing yet linked exchanges, what happens if some exchanges quote in pennies and others do not? Quoting in pennies is a change to be fostered. However, the rush to innovate must be tempered with the fundamental principal of maintaining fair and orderly markets.
As many of you are aware, the Commission's examination staff spent time late last year educating themselves about options order routing and best execution practices. Commission staff met with firms representing approximately 40% of all options order flow to evaluate how brokers are fulfilling their duties of best execution in the handling of customer options orders and how order routing practices have changed since December 2000, when the staff last studied this issue, soon after the advent of widespread multiple listing.
It is encouraging that these examinations revealed significant improvements over the last five years in firms' options order routing processes and that the use of "smart router" technology has become more prevalent. Smart routers are generally designed to immediately review the displayed prices and sizes of quotes at each of the six options exchanges and then route marketable orders to a market displaying the best price. Because more than one exchange frequently displays the best price, however, firms continue to rely on factors other than price to determine where to route customer orders. In particular, factors such as payment for order flow, internalization, reciprocal arrangements, and other inducements continue to play a substantial role in broker-dealers' order routing decisions.
Unlike in the stock market, where payment for order flow virtually disappeared following the move to decimal quoting, payment for order flow and internalization practices have become more pervasive in the options markets than they were in 2000. So what does this trend indicate? A firm's receipt of payment for order flow or its decision to route orders to an affiliated dealer does not, by itself, violate best execution obligations. Though, the examinations by Commission staff did reveal that most firms examined have been unwilling to pursue better prices for a meaningful amount of their order flow that may be available in penny auctions offered by several exchanges. A broker cannot ignore price improvement opportunities for its customers because it could impact the payment for order flow or internalization arrangements it has in place.
The duty of best execution requires a broker to periodically assess the quality of competing markets and take into account price improvement opportunities. Such price improvement opportunities are increasingly available on the options exchanges. As these opportunities grow, executing customer orders at the best displayed price may not satisfy a broker's best execution obligations.
Commission staff plan to conduct additional examinations of order routing brokers. Not surprisingly, staff will be looking at whether brokers are, in fact, analyzing execution quality information from all six options markets and making informed order routing decisions based on the results of that analysis, including whether there are meaningful opportunities for price improvement. We are particularly focused on those brokers that appear to make order routing decisions based on inducements, such as payment for order flow or internalization. Where such conflicts exist, brokers should be able to explain why their order routing decisions satisfy their best execution obligations.
Even without attracting a significant amount of order flow, the existence of penny auctions, coupled with intense competition among the options markets, has generated a great deal of interest in publicly quoting options in penny increments. The persistence of payment for order flow, and the growth of preferencing arrangements, which create conflicts of interest, also suggests that the time is ripe for options exchanges to quote a small number of options in pennies. Moreover, a limited analysis by the Commission's Office of Economic Analysis indicates that, for the most-actively traded options, the national best bid and offer is at the minimum increment for more than 50% of the trading day. Such statistics suggest that the existing nickel and dime increments are keeping spreads artificially wide. Penny increments could be expected to narrow spreads. And narrower spreads directly benefit customers.
For these reasons, I believe that it is not a question of whether options will be quoted in pennies, but how pennies will be introduced to the marketplace. While it may be preferable for all exchanges to quote in the same increments, achieving such uniformity could result in a significant delay in the availability of better prices to customers. For this reason, we are considering whether to set a date by which those exchanges interested and ready to quote in pennies could do so in a limited number of options. The decision as to whether or not to participate would become a business decision for each exchange.
There are a number of important issues that need to be addressed before exchanges begin quoting in penny increments, particularly if not all of the options exchanges choose to quote in pennies. Under the Intermarket Options Linkage Plan, exchanges are required to avoid trading at worse prices than those offered on another exchange. This requirement means that, even if an exchange does not quote in pennies, it could not trade at prices inferior to those offered in pennies. Should an exchange that does not permit quotes or orders in pennies be permitted to step up to match a better price quoted in pennies on another market? If an exchange not quoting in pennies only permits certain market participants to step up to match, such a practice would raise important questions of fairness.
The Linkage Plan also requires that, if an exchange does trade through a price offered by a customer order on another exchange, the aggrieved exchange is entitled to send a Satisfaction Order. Would the systems of an exchange that does not quote in pennies be capable of accepting a Satisfaction Order at a price in pennies?
Finally, to calculate a national best bid and offer and for surveillance purposes, an exchange's systems would need to be able to read quotes in pennies disseminated by other markets even if the exchange itself chooses not to quote in pennies.
Penny quoting in the stock market has led, in some cases, to flickering quotes. There is the potential even likelihood for pennies to increase the incidence of flickering quotes in the options markets. Such flickering quotes could lead to a greater number of unintentional, or apparent, trade-throughs. By starting to quote in pennies in only a small number of options, it would allow us to observe the impact, if any, on transparency.
There is no doubt that quoting options in pennies will increase quote message traffic. It is this additional message traffic and its potential to overwhelm data systems already heavily burdened with options quote messages that has been the basis for options exchanges continuing to quote in nickels and dimes. At this point, however, there is only speculation as to the severity of the impact. By beginning to quote only a small number of options in pennies, the impact of pennies on systems capacity can be assessed.
Moreover, while industry-wide quote mitigation strategies have been unsuccessful, we anticipate that exchanges choosing to quote an initially small group of options in pennies would also devise mitigation strategies. Unlike previous mitigation efforts, the exchanges would not have to reach consensus on mitigation ideas. Instead, quote mitigation strategies could reflect the unique business models, capacity usages, and systems functionalities of a particular exchange.
Today, the effect of penny pricing on the options market remains unclear. I do not expect that this will remain the case for much longer. Fortunately, we have some experience in converting to pennies in the stock market. Though there are clearly important differences between the stock and options markets, the conversion to pennies in stocks started with a pilot program and gave everyone an opportunity to study the impact of pennies on market quality and systems. These are many of the same concerns that are expressed about moving to penny quoting in options.
Although we cannot be certain at this time that penny pricing will be as beneficial to customers and the industry itself as we might hope, this is clearly an opportunity for the industry to evolve beyond the existing payment for order flow/internalization model.
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