Speech by SEC Staff:
2003 0ptions Industry Conference
Associate Director, Division of Market Regulation
U.S. Securities and Exchange Commission
April 25, 2003
Good morning. I am delighted to once again have the opportunity to attend the Options Industry Conference. Preparing my remarks for this conference afforded me an opportunity to reflect on events of this past year and their implications for the industry. There can be no doubt that the challenges facing our nation have affected the options industry. The erosion of investor confidence caused by accounting scandals, a recession, concerns about terrorists and a war have resulted in depressed market values and significantly reduced volume. Everyone is once again asking the question of the 1970s: When will the "little guy" return to the market? It should come as no surprise to anyone that the answer to that question in 2003 is the same as it was in 1975 - the "little guy" will return as soon as he regains confidence in the economy in general and the integrity of the marketplace in particular.
While several of the issues affecting investor confidence are out of our control, there are market integrity issues that we must address that will help reestablish that most valuable market components - investor confidence. Today I would like to address two areas that the Division is working on that go to the heart of the issue of market integrity: Payment for Order Flow and Internalization, and Options Market Linkage. As always, before I begin my comments, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff. 1
Let me begin by stating that the Commission's principal mission is to protect investors. And an essential component of this mission is the Commission's efforts to provide an environment in which best execution can reach its full potential. No reasonably informed investor will participate in a marketplace unless he believes he is getting the best execution possible.
Payment for Order, Internalization and Similar Practices
Best execution is difficult to evaluate in an environment in which practices, such as payment for order flow and internalization, are commonplace. These practices in the options markets have received increasing attention from numerous quarters. And, I think I can safely say, that as these practices have grown, so have the criticisms. There is somewhat of a paradox in payment for order flow and internalization: There is no doubt that these practices were the result of competition among the exchanges. While at the same time, their widespread utilization can diminish price competition and present best execution concerns that ultimately impact on the integrity of the marketplace.
Payment for order flow and internalization were the almost inevitable consequence of the expansion of the multiple listing of options, beginning in the fall of 1999. Multiple listing, quite simply, encouraged greater competition among the exchanges for order flow. This competition has taken many forms. For example, transaction fees for customers have all but disappeared, exchanges are now disseminating the sizes of their quotes and have expanded the size and type of orders that can be automatically executed on their markets, and, more recently, some exchanges' quotes are firm for broker-dealers and customers. In addition, more exchanges are planning to offer their market makers the ability to disseminate independent quotes. This promises to bring greater intramarket competition, which we have already seen improve disseminated quotes.
These changes have been very positive. But, this competition has also taken the form of incentives directed at the intermediaries of customer order flow. Payment for order flow and internalization opportunities are designed principally to benefit the firms' representing customers' orders.
There are two distinct concerns that arise out of these practices. The first is a question about the impact that such practices have on the incentives for market participants to compete on the basis of price. Do market makers have a disincentive to quote aggressively if by doing so they dissuade firms looking to internalize customer orders from bringing their order flow to the exchange? On the other hand, a prohibition on these practices would not necessarily ensure or encourage more competitive quoting.
Moreover, in spite of these practices, there is evidence that over the past three years spreads are narrower and the incidence of trade-throughs has decreased. An economic study I have seen that is soon to be published shows that between June 2000, a time when multiple listing was still in its infancy, and January 2002, eighteen months later, average effective spreads for small trades declined from 22 cents to less than 9 cents in actively-traded options. This represents a decline of nearly 60%. The study also found that trade-through rates in the actively-traded options fell during the same period from just over 4 percent to just over 1 percent. While it is not yet clear what led to this steady decline, the results are clearly positive for investors.
The second concern raised by payment for order flow and similar practices is the conflicts of interest they create between a firm's duty to obtain best execution for its customer and its inclination to maximize the value of its customer order flow. Will broker-dealers have their customers' best interests in mind, or their own rewards, when they are deciding where to route orders? And if there is value in an order, why should it not belong to the customer? It is not clear to us right now that the value derived from customers' orders is passed on to them, either directly or indirectly.
Particularly in today's climate, when the confidence of investors has been so deeply shaken, these questions are all the more important to put on the table. For this reason, as has been reported, the Staff is planning to recommend to the Commission that it issue a Concept Release to publicly articulate the causes, implications, and alternative responses to these practices and to provide an opportunity for the public to comment.
Some of you may be wondering why the Commission has not, to date, taken regulatory action to address the practices of internalization and payment for order flow in the options markets. Over the past few years the competitive dynamics in the options markets have undergone extraordinary changes. Payment for order flow and internalization, as I mentioned, are themselves a product of competition. And, competition, when it is fair and healthy, is the lifeblood of a sound marketplace. It is not clear yet whether these practices are themselves a competitive breakdown, or merely symptomatic of inadequate competition in the pricing of options. As pricing in the options markets becomes more competitive, these practices may disappear (or at least become less prevalent) without Commission intervention.
The goal of a concept release would be to obtain meaningful comment before deciding whether regulatory action is appropriate to improve the efficiency of, and to dampen the conflicts of interest that impede, price competition.
Options Intermarket Linkage
Another very important component in our market integrity equation is the linkage of the options markets. With options trading on as many as five exchanges today, the linkage is an integral component of a national markets system and helps to assure that an investor's order will be executed at the best price available.
As I'm sure you know, the options exchanges have been working for several years now to develop and implement the linkage. The Commission ordered the exchanges to develop a linkage plan in October 1999 and approved a proposed plan in July 2000. Since then, the exchanges have worked together on the details of how the linkage is structured and implemented. And, on January 31st this year, the options linkage became operational for the automatic execution of certain orders. I would like to congratulate each of the options exchanges for all of their hard work, dedication of resources, and cooperative effort. None of us should underestimate the enormity of the task that the options exchanges were faced with and the challenges they overcame to achieve a working options linkage.
As of the second week in April, more than 60,000 orders had been sent through the linkage. And, each day approximately 1300 orders are sent through the linkage. I expect that these numbers will grow as the exchanges move into the second - and final phase -- of linkage implementation. The rollout of Phase 2 is beginning today with 14 classes and the linkage is scheduled to be fully functional by June 9th.
Overall, implementation has been successful. Obviously, any time something new is introduced, it requires a period of adjustment. I am confident that the exchanges will continue to work together to provide an efficient linkage for the benefit of customers.
It is also critical to the success of the linkage that each exchange ensures that the requirements of the Linkage Plan are adhered to by exchanges and their members. Of paramount importance is that customers' orders be executed at the best available prices. In addition, now that linkage provides market makers with access to other exchanges' quotes, locked and crossed markets are no longer inevitable.
Finally, it bears mentioning that specialists' and market makers' obligations to be firm for their quotes under the Commission's Quote Rule applies equally to orders received through the linkage. While the Linkage Plan or exchange rules may supplement the requirements of the Quote Rule, they cannot diminish the requirements imposed by that Rule. Obviously, this will remain an issue of primary importance to the Commission.
I've spent some time this morning talking about two areas in which the Staff and the Commission have has been focusing time and resources. The underlying concern is the impact that market practices and structures have on market integrity and best execution.
It bears repeating that best execution remains an essential component of broker-dealers' fiduciary duties. The Commission has not, to date, taken the position that payment for order flow and internalization are inconsistent with best execution. But there is little, if any, disagreement that these practices create a conflict of interest between a firm's own interests and its duty to obtain the most favorable terms reasonably available for a customer's transaction. These conflicts may tempt some firms to take their customer orders to the market whose members won't compete with them for the trade, denying a customer the opportunity for a better price.
In addition, the implementation of the intermarket linkage is a positive step for market integrity. The linkage, along with rules that limit trade-throughs, can improve the likelihood that customers' orders will trade at the best available prices. Trade-through rules, however, do not consider opportunities for price improvement within other market centers and, therefore, are not sufficient by themselves to ensure best execution of customer orders.
Thank you for your kind attention.
|1 || The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.