Speech by SEC Staff:
Remarks before the 2003 0ptions Industry Conference
Associate Director, Division of Market Regulation
U.S. Securities and Exchange Commission
Bonita Springs, FL
May 13, 2005
It's a pleasure to participate again this year in the Option Industry Conference. When I began preparing my remarks, I reflected on the significance of holding this conference on Friday the 13th. Legend has it that the date's unlucky reputation traces back to October 13, 1307, when King Philip IV of France carried out a series of mass arrests that left thousands of Knights Templars in chains, charged with heresy, blasphemy, and various obscenities. While none of these charges was ever proven, hundreds of Templars suffered excruciating tortures and more than 100 died under torture or were executed by burning at the stake. You're probably wondering where I'm going with this. You can relax. I say this to remind you how lucky you are to only have to suffer through a few speeches between golf games.
At the outset, let me remind you that the views I express are my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.1
Let me begin by saying that I believe that everyone here should be proud of your contributions to the development and growth of the options markets over the past five years. The options markets are a better place for customers and other market participants than they were just a few years ago. And, the quality of the options markets continues to improve each year. Spreads across the options exchanges narrowed following widespread multiple listing in August 1999 and consistently remain at those levels. The size quoted at the inside has increased steadily over this period and the displayed quotes on exchanges are more immediately accessible than ever. In addition, liquidity - to the extent represented by total contract volume - has grown more than 60% since 2000. Last year, more than a billion options contracts were traded. Finally, the Options Intermarket Linkage and the requirement to avoid trading through better prices available have contributed to better executions for customers.
To a large extent, a combination of competitive influences - including the launch of two new options exchange and structural and regulatory changes -- led to these market quality improvements. The byproducts of this changed competitive landscape have also had an impact on those of you who make your living trading options. For example, there has been a consolidation of firms into what is now a small number of large, integrated firms. A few years ago, many expressed concern that consolidation among options market makers could result in less competitive markets. Fortunately, this does not appear to be the case as we have seen new liquidity providers enter the market. Another byproduct is the development of payment for order flow and internalization - which I feel no speech by Commission staff at this conference would be complete without mentioning.
Strong opinions about these practices are common. And, many seem bewildered as to why the Commission has not banned practices that are so rife with conflicts of interest. I must agree that these practices create a conflict of interest between a broker's best execution obligation to its customers and the broker's own interests. But, it is not clear that banning these practices by itself would mean that customers would get better prices. Payment for order flow and internalization are symptoms that pricing inefficiencies remain -- despite the significant progress that has been achieved in the options markets. Without improvements to the prices at which options trade, banning payment for order flow or internalization would improve the profits of dealers, but do little for customers.
In February of last year, the Commission published a Concept Release discussing the changes in the options markets since multiple listing and, in particular, the practices of internalization and payment for order flow. Critics of these practices assert that they are detrimental to quote competition and interfere with a broker's best execution obligation. The benefits of these practices to an exchange's business may also conflict with that exchange's self-regulatory obligations. The Commission asked for comment on several initiatives that it could undertake to address concerns about payment for order flow and internalization, including banning some or all of these practices, moving to penny pricing increments and execution quality disclosures by the options exchanges. Not surprisingly, the comments the Commission received in response to the Concept Release expressed a wide range of view on what actions the Commission should, or should not, take.
The Commission's approach, to date, has not been to restrict payment for order flow directly in either the equities or options markets. Instead the Commission has relied on improvements in the transparency and quality of markets - which directly benefit investors -- to reduce or eliminate these practices.
The move to decimals in January 2000 reduced the minimum quoting increment for options by 20 percent. The ability to narrow the quoted spread in options, however, continues to be limited by the ten-cent and five-cent minimum pricing increments. A move to penny pricing increments in options could substantially reduce or eliminate payment for order flow. Based on experience in stocks, as the amount of profit a dealer can make from trading the spread declines, so too does the amount of money that dealer is willing to pay for attracting orders. The move to penny increments greatly reduced spreads in those securities trading in pennies and narrower spreads have been cited as one of the factors that led to a decrease in the use of payment for order flow in securities traded in pennies. Payment for order flow could similarly be reduced in options if spreads were narrowed. The benefits from narrower spreads flow directly back to customers; the benefit to customers from payment for order flow is, at best, indirect.
As I'm sure you know, options message traffic is already growing at a blistering pace. Penny pricing would dramatically increase quote traffic and the corresponding burden on systems could diminish the quality and timeliness of options quote information. While pennies may ultimately be the answer, we continue to evaluate whether the potential benefits of penny quoting would justify the risk of less accurate information being disseminated.
Because the five-cent and ten-cent quoting increments limit the prices that can be disseminated, brokers' best execution decisions are even more critical. And, in a market with internalization and payment for order flow practices, it is vitally important to focus on ways to further the ability of brokers to achieve best execution for their customers' orders.
As I noted above, the Options Linkage Plan contains an intermarket trade-through requirement. This rule is designed to reduce the incidence of one market center executing an order at a price inferior to the best displayed price on another market. This requirement serves to "backstop" a broker's duty of best execution at the exchange level on an intermarket basis. However, it is a fundmental obligation of the broker itself to fulfill its best execution obligations to its customers, and not just rely upon the requirement for a market center to which it routes an order not to trade-through. Although the trade-through obligations are important to the execution of orders at the best available price, it is equally important not to lose sight of a broker's independent duty of best execution.
Every broker is familiar, I am sure, with its existing best execution obligations. These obligations derive from common law agency principles and fiduciary obligations and are incorporated in SRO rules and, through judicial and Commission decisions, in the antifraud provisions of the federal securities laws. Specifically, the duty of best execution requires broker-dealers to seek the most favorable terms reasonably available under the circumstances for a customer's order.
This duty is not inconsistent with the automated routing or execution of orders, and does not require automated routing on an order-by-order basis to the market with the best quoted price at the time. Rather, the duty of best execution requires brokers to periodically assess the quality of competing markets to assure that order flow is directed to the markets providing the most beneficial terms for their customer orders.
A broker's requirement to periodically assess the quality of competing markets is dynamic in nature. Brokers must take into account the changing nature of the market. Brokers must examine their order routing practices for seeking best execution in light of market and technology changes and modify those practices if necessary for their customers to obtain the best reasonably available prices.
What exactly does this continuing assessment mean, in the context of the options markets? The Commission has stated that brokers must take into account price improvement opportunities across markets. This aspect of best execution is most often mentioned in the context of equity markets. However, it is also relevant for the trading of options. Because options currently trade in five-cent or ten-cent price increments, there is room for improvement between the quoted prices. Intermarket competition has led to trading rules and systems that provide opportunities to trade options at prices better than the displayed price. I do not believe that brokers can simply ignore opportunities for, and the realities of obtaining, price improvement when making their best execution determinations with respect to customer options orders. And, brokers especially cannot permit the receipt of payment for order flow or internalization arrangement to interfere with their best execution responsibilities and determinations. Thus, getting the customer the NBBO on an options trade may not always be good enough - brokers should take price improvement opportunities into account in their "regular and rigorous" review process. In addition, as part of their best execution obligations, brokers also must take into consideration whether different markets may be more suitable for different types of orders or particular securities.
Execution Quality Statistics
Given the importance of a broker's best execution obligations, particularly in an intensely competitive marketplace with multiple, competing exchanges, it is essential that brokers have the tools necessary to assess and compare execution quality across exchanges. It is also essential to assure that customers are able to effectively monitor their brokers' handling of their orders. Changes in the options marketplace over the last few years have contributed substantially to brokers' ability to monitor execution quality across exchanges and customers' ability to monitor their brokers' executions of their orders. For instance, price and quote transparency have improved with the creation of a consolidated best bid and offer, and quotes are now disseminated with size. Exchanges trading listed options are now linked together through the Options Intermarket Linkage, allowing the markets to more easily access each other. Further, options exchange participants are now subject to firmness requirements for their displayed quotes. In addition, brokers are required to publish quarterly reports detailing where they route their customers' options orders for execution and the relationship the broker has with the exchange to which it routes orders, including profit-sharing and payment for order flow arrangements.
To further facilitate the achievement of best execution, and in response to comments received on the Concept Release on the options market that the Commission published in February of last year, the Commission staff is looking into developing a proposal to require exchanges to publicly disclose standardized execution quality statistics on their trading of options. We envision that this rule would be patterned on existing Rule 11Ac1-5 for stocks, which we believe has been very useful and worked very well. We fully recognize, however, that changes would have to be made to accommodate the trading characteristics of options, particularly taking into account the many series of each options class.
I know that the options exchanges have, at the urging of their members, developed execution quality data that they make available to those members for use in their best execution assessment of the performance of each exchange. This is a great development. These statistics, however, are not completely uniform. The exchanges use different parameters, making the comparison of execution quality across exchanges imperfect. This information also is not publicly available.
Brokers and their customers may benefit from standardized and publicly available execution quality statistics across options exchanges and the Division of Market Regulation plans to recommend that the Commission propose rules that would require exchanges to publish information in a uniform way to permit apples-to-apples comparisons across markets. Also, like the execution quality information that is available for stocks, we plan to recommend that this information be publicly available so that customers themselves can better monitor their brokers' execution of their orders.