From: Casey Platt Sallerson & Troob, LLC 440 S. LaSalle, Suite 900 Chicago, IL 60607 (312) 260-5855 firstname.lastname@example.org
To: SEC - File No. S7-07-04
Re: Response to SEC's Concept Release: Competitive Developments in the Options Markets Level the Playing Field
The options market has changed because of the conflicts of interest that have developed with payment for order flow (PFOF), broker/dealers, and order internalization. The nature of the change in options pricing is a function of the different levels of competition that have been created. A transparent, seamless market place would "level the playing field" for all participants and would mean the most accurate, competitive customer pricing for all looking to take and hedge market risks. Competition at all these different levels has created order competition, which has nothing to do with price competition, and actually distorts pricing.
1. Payment for order flow (PFOF) increases transaction cost therefore is a disincentive to trade. It acts like a tax on trading costs and makes many trades less attractive. The actual costs involved in trading have decreased radically in recent years. Trading by its nature is a transaction between those who are willing and able to take risks. PFOF is competition for orders not for price. Customers are not receiving the commission benefit from order flow payment trade by trade. It creates a greater conflict of interest when a broker must decide between best execution price and the price he receives for order flow. The time wasted deciding where an order should be sent is market risk customers pay for every day.
2. Spreads between bid and offer have narrowed because the amount of interest in the business has grown. They have also narrowed because technology has allowed more people to quote more stock options more quickly and accurately. We have just begun to scratch the surface of the number of people who understand options. Technology provides a means to process more complicated mathematical problems more quickly. Competition and trade will bring more trade and better option pricing.
3. The comment that quotes are "set" implies that every participant has the same agenda, same position, and same business model. Bids and offers are part of a liquidity provider's trading strategy that changes minute by minute because of market dynamics. Liquidity implies that there is trade or interest in an underlying security. The volume or interest in an underlying security will be a lead to option trade.
4. Yes, specialist guarantees affect quoting. Specialists were "pitched" to customer houses as a means to put a face on a trade. Similar to stock specialists who trade for themselves as well as provide an "orderly market" (Who should really determine what orderly is?). A DPM's markets are always posted to provide the liquidity need. The idea that a customer would feel more assured that a person will "look out for" their order and handle it favorably is a misnomer and a conflict of interest. The ability to trade against one's order flow is the conflict of interest and the root of the problem. The specialist system creates another level of competition a customer must compete against. Shouldn't everyone wanting to take risks take the same risk? If all market participants have the same participation rights, isn't the correct price a function of the market risk taken at any given instance? Why should anyone have a greater right to participate than anyone else? Everyone should take equal market risks it would make more orderly markets.
5. The aggressiveness of a market maker quote is a function of the liquidity and therefore impacted because liquidity is removed and no value is added. Trade begets more trade. If a portion of an order is given to any other entity it will ultimately effect bid and offer size. If everyone has the same information about an order at the same time, the most competitive price will be established. Internalization hurts all market participants because someone has information prior to the order reaching competitive liquidity providers. The best price discovery is when the maximum buyers and sellers have equal time to price the same order. Internalization takes liquidity and value from the market place.
6. It is impossible to determine the depth of inaccurate price discovery that payment for order flow causes. PFOF creates order flow competition before price competition. It only hurts truly competitive pricing of options by subjecting orders to outside interest of brokers. It means someone is trying to put a monetary value to an order in addition to the commission. That means that someone is trying to get something other than the best price for the customer to maximize one's own interest. Do you think orders would receive better execution prices because of PFOF? The NBBO changes rapidly because of the dynamics of the underlying security. It's virtually impossible to insure all trades receive NBBO with 6 venues quoting and an order at just one location. Every order should be subject to the same market risks (and not execution risk).
7. Trading decisions can be influenced currently by the perceptions developed about the type of business a broker is executing. If the first time we meet, you "bloody my nose", the second time, your reputation will proceed you. It really doesn't matter what kind of business we do the second time we meet. Additional transparency of option orders and the underlying security would provide for better option pricing.
8. It would be better never to have the ability to distinguish between orders. The ambiguity would provide for more honest quotes and size. If all market participants have the perception that all information on an underling security is known at any given instance, market depth would increase. If all market participants have access to all hedging potential, at any given instance, markets would be deep and liquid. Its difficult to sell 500 calls if the NASD market quote is showing 1000 common offered.
9. Trading at better than a quoted price is a function of trade itself. The ability to make a trade will provide a means to make another trade. A trader would always rather trade an option versus an option position than stock. At any given instance an order will receive a better price if I can trade an option versus my position than stock. Trading at better prices is also a function of market dynamics. I want to know how much of the volume, on a percentage basis, each exchange trades from other exchange members (It would demonstrate to you the condition I'm speaking of).
10. Elimination of payment for order flow would encourage trade and be a step toward "leveling the playing field". Again, if a professional order fits my position at any given time; I can use it at a better than disseminated price. If yet another order is available after making that trade, it may trade at a better price. Option positions fit together like puzzle pieces and trade begets trade. Removing the tax known as PFOF would mean fairer, more equitable trade for all.
11. Internalization creates less competition not more. It's bad for customers and bad for any open system. Any marketable order that does not get exposed to ALL liquidity providers is subject to the influence of a brokers' personal interest first. How can that be good? It seems improbable that you can find an instance where order execution and trading can co-exist fairly. How did it start in the first place? Again, exchange based auction trading provides the fairest price discovery. Internalization takes liquidity and value from the market place. It adds an air of cynicism that someone has an unfair advantage, whether seeing an order first or working stock from a different level or some PFOF is in play that no one can compete against.
12. No, because some internalized orders are priced before they reach the exchange floor and price improvement isn't possible. Orders that are pre-priced before they reach all potential buyers and sellers are competitively disadvantaged. Individual exchange members price options constantly, providing liquidity, and should always be given the opportunity for price improvement. It's best for customers to have their orders offered to the greatest number of liquidity providers.
13. From a trader's perspective, the SEC does not witness on a day by day or trade by trade basis the way options are traded. I've worked at CBOE for 17 years in a variety of capacities. This response is as close to personal contact with the SEC I've ever had. I'm glad to respond and I say keep asking questions of your members about their trading policies; it's your job.
14. The conflict that payment for order flow creates is deeply rooted in brokerage; it's impossible to ever attempt to eliminate it. It goes beyond exchange sponsored cash payment for order flow. The SEC is in the middle, a referee, an organization developing rules to protect all interests. The SRO's needs to continue to educate the public on exactly what their options can do for them. "Let the buyers beware", because so many people perceive trading as a casino rather than a tool to enhance profitability and protect against risk.
15. Yes, because there is a misconceived notion that customers have loyalty to a specific exchange. People who work at the exchange feel an attachment financially and spiritually. But we sense that there are other types of payments, between friends, and relationships that SRO's cannot account for. A lot of people who work at the exchange have moved up because of the relationships they have developed over the years. But in reality, as an individual member you must understand that everyone is looking out for themselves. "Keep your friends close and your enemies closer". Yes, any kind of order flow payment affects my ability to quote. While exchange sponsored PFOF is bad, other forms are even more corrupt and less transparent.
16. I don't think anyone really knows, honestly, if a customer ever sees the benefit in reduced trading costs from the payment the firms receive for order flow. How could a SRO ever check to see that payment is going to the correct places? It would really be difficult to ever fully regulate payment for order flow. A cost/benefit analysis should be done to see if payment for order flow improves customer satisfaction.
17. We need a SRO that is constantly monitoring and finding ways to balance all interests. The business changes day by day and trade by trade. Please keep regulating. Please keep asking intelligent questions. Please keep looking out for the best interest of all parties. Please create a universal book for all stock and option orders so that all market participants can see all orders. Please allow all market participants to see order books. Please increase the transparency of markets for the benefit of all participants.
18. It seems that the end of the last true bastion of capitalism is near. The idea that a person can create a living as a sole proprietor and individual exchange member is coming to an end unless you act to ban competition on these varied levels. While decreasing bid-ask spreads is good, payment for order flow, specialists and dealers who solicit orders before they are displayed for all market participants to see is a conflict in their fiduciary responsibility.
Exchanges have disseminated quotes to determine the best available price at a specific time. The dynamics of technological change may mean the end for many floor -based operations. But liquidity providers will always be needed. You need a buyer and seller for all trades. You need price discovery. The fact that some orders have the other side before anyone can offer price improvement, or are available to the entire trading community is inherently wrong. How can it be that some orders we see on the floor have prearranged solicited orders on the other side? Shouldn't ALL participants have ALL available information at the same time?
If competition and fairness is what you seek, level the playing field. Taking a risk and providing liquidity is why markets exist. The customer is not well served by competition for orders. Doesn't that imply there is competition within a firm for who will pay the most for the order? Therefore, a broker will put his own interest in front of the customer order to earn the most from that order. We haven't even gotten to the best possible price. Customer orders subject to payment for order flow arrangements must inherently receive poor order execution.
Internalization and specialization puts too much pricing power in too few hands. Eliminate the conflicts of interest by recognizing them for what they are. The different levels of competition that have evolved have created a fragmented marketplace. There is now a place to cross orders, a place to solicit orders, and a place to print orders. Never is it mentioned that an order can be most competitively priced where there are many buyers and sellers offering meaningful opportunity for price improvement. They all come together in floor based trading today.
If there were one marketplace where all participants could seamlessly, transparently trade, would not trade be the fairest? If competition were purely based on price, wouldn't the fairest price be discovered?
19. Yes, rebate the customers. Why should they have to pay for the privilege of trading? Perhaps pay for maintenance of their account annually, but not for trading. It's wrong that people pay for order execution when a simple point and click is all that's required. Or level the playing field, everyone who trades, who takes risks, pays the same commission.
20. Wouldn't a non-cash payment be just an outright bribe? For example, I ask you out to golf at my country club every Saturday at 7:00 am. You can monetize the cost of the golf, but not the value of the prime tee time. In return, you send me your orders. Isn't that kind of nepotism the very root of the mistrust in the securities industry? It's a part of the business that will be impossible to regulate. The value is unfortunately immeasurable.
21. Cash payments for order flow should be banned. The way it's used now it's virtually extortion. The people who do not benefit, the customers, who take the risks, really never get the benefit from it. I was just at a meeting where we discussed increasing PFOF because other exchanges paid more than CBOE. That says to me that price discovery is meaningless. It means those who send orders have less incentive to get the best order execution price.
How about taking all the PFOF you currently estimate is out there and set up educational or promotional seminars to teach people how to use the markets correctly? How about using the money we spend for PFOF and improving our systems for better order execution?
Non-cash order flow payments have many forms. You can't really stop a friendship. You cannot measure the influence friendships have on the terms of option prices. That in itself is the argument for point and click trading, no outside influence on the decision-maker.
22. The idea of a broker acting also as a dealer to me is the root of the problem. How can the broker truly put the customer interest in front of the firm that employs him? Revisiting the conflict of interest issue is the first and biggest step in leveling the playing field.
Internalization must be one of the most profitable new sources of revenue for firms. It has become common place for a firm to buy another firm's orders for the single purpose of trading them. Internalization breeds more internalization as seen by firms buying NYSE specialists and DPMs. Isn't this simply a firm acting as both a broker and a dealer? It means people are trying to monetize the value of orders at customers expense.
Brokers acting as dealers are yet another level of competition within the trading arena. They see orders that no one else does and have entire upstairs operations that pick and choose what they send to the floors. Market makers often trade off trades derived from those trades. Everyone suffers from broker/dealer trading arrangements. It doesn't add any value to the pool of liquidity; it just picks and chooses which orders to trade and "skims the cream".
The most pervasive wrong is again done to the customers. Their orders are never exposed to all potential liquidity providers for the most competitive market. Internalization eliminates the opportunity for price improvement. When brokers act as dealers do their trades ever hit the tape? Free trade will beget more free trade.
23. Specialists are no longer providing the only auto quote at the CBOE. They take up to 40% of orders. Why? They once fought for new business and took risks such as listing ADR's or OTC option classes. It seems now the DPM or LMM systems' usefulness has run its course. Most of the people who originally took those risks have moved on and their bold moves were rewarded. The key is that the risk takers should be rewarded. Today you see brokers buying these firms as a means of potentially capturing order flow. Truly free markets mean that risk takers are rewarded for the risk they take and the ability to trade and manage risk. Interfering with free trade whether it is payment for order flow, specialization or internalization crosses over the lines of free trade.
24. Banning payment for order flow would bring a more level playing field for all market participants. It would bring more price competition rather than order competition. Trade begets trade. If you allow market forces of supply and demand to determine price, then the most accurate level of equilibrium can be achieved.
25. Customers benefit from all forms of free trade. The risk taker, whether it's the customer or liquidity provider, should be the least encumbered party in trading. Pure, one on one competition, is the best for all market participants. The fairest prices will only be established when all participants are on equal footing. Price competition arising from trade will create the fairest prices. It's impossible to create fair pricing through PFOF or internalization. The best way to create pure pricing is for the market forces to lead to the best price.
26. PFOF affects all pricing across every market. Any cost involved in trading will effect the absolute best execution price a customer will ultimately receive no matter what market. It only seems fair that all market participants have the same execution costs so that the most competitive price can be established.
27. Eliminate PFOF; it distorts accurate price discovery. Let all risk takers have the same ability to take risk because of market dynamics, not artificial influences. Technological advances have made the specialist system obsolete. Price discovery is still where the buyers and sellers can compete for and take risks that are beneficial for all.
28. Whatever form of PFOF is being used; it is negatively influencing pricing. Customers do not receive an aggregate price reduction from PFOF. I firmly believe that price discovery will most accurately be reached when trade is least influenced by factors outside the market dynamics.
29. "A meaningful opportunity" means that price improvement is possible. It's also when the maximum amount of buyers and sellers has opportunity to trade an order, not simply a firm using a screen market. Market dynamics create fair trade and should be the determining factor in pricing.
30. Yes, but why should any firm be allowed to trade against it's own order flow? Doesn't internalization create a conflict of interest in the long run? If not, then why are firms buying up other firms and their order flow? Conflict of broker dealers' interest is why people want more seamless point and click trade.
31. Regulation will become more efficient as trade becomes more technologically advanced. Trade becomes less transparent, quicker, and cost efficient. But dealers should not be allowed to "work orders" unless they are held to their actions. Any one who plays with market dynamics should be held to the same level of responsibility.
32. Yes, in the case of if-then orders, liquidity providers are being played, so a firm can shop an order. A broker says, "If I had an order, could I participate at X percentage?" It implies that an order exists and someone has seen it ahead of anyone else. Further, it suggests that unless they get their way the order won't trade at all. Why should anyone have such power over orders and pricing? All who take risk should have the same ability to trade with an order. These situations where no transparency is available is wrong. While a firm is correct in not giving a crowd all the information about the total size of an order, it should not be allowed to play with orders so that it can receive the most commission from playing one exchange against another. Any order that has a matched buyer and seller before it is exposed to the market is internalized and therefore accurate price discovery is eliminated from trade.
33. Facilitation guarantees simply mean that someone who has paid for order flow gets a better price because they traded before the order was exposed to all buyers and sellers. I recently saw a four-way roll that we showed the broker ten cents away for 200 by 400 by 300 by 500. The broker, within seconds, says he'll take the other side ten cents better than we showed him and will trade all of it. He could not even have made one phone call and he had the other side. In other words, he had the trade placed before being exposed to any liquidity providers. While we didn't offer price improvement it means someone had the ability to work stock before the order was presented. Isn't that basically front running? Isn't that an indication someone paid for the look at that order before it was exposed to the market? Level the playing field so transparency can instill market confidence.
34. Any and all information adds to transparency and therefore benefits customers. Customers want simple and seamless execution quality and so do exchange members. Provide rules that allow for the fairest customer entitlements and you will boost their confidence in the financial markets.
35/36. Although not a popular stance, I believe that global order book is a great idea. More people see more orders all at once. Book marketable orders directly and let market dynamics price orders. Get rid of if-then orders and let every one have the same opportunity to trade. Why should anyone be responsible for how fast orders must be booked? Order books should be electronic and risk takers all have the same participation rights to those books.
37. It really seems you confuse competing for orders with competing for prices. PFOF is competing to see who can pay for orders and stay in business. Price competition for options is largely based on the amount of trade of an underlying security and its options. Trading in pennies would not necessarily reduce payment for order flow or the competitive drawbacks it brings.
38/39. Trading in pennies would add to the amount of quotes exchanges disseminate. It would strain the system until it could catch up technologically and further find an equilibrium that benefits all market participants. It would be money better spent to improve technology for quote dissemination and capacity, in whatever increments, than spending another cent on PFOF.
40. Day by day we live with electronic bandits that take advantage of bad underlying quote prices and pick trades clean because of quote problems. These arbitrageurs add nothing to the markets and simply take advantage of rapidly changing quotes. Yes, there would be more "flickering quotes" and less transparent depth to markets.
41. Individual members already pay fees to set up and send quotes. We also pay for software and hardware that enable us to quote. Paying to put up quotes means that a trader must think strategy about every bid and every offer disseminated to the exchange. The current hybrid system enhances price competition because of the importance each bid and offer brings.
42/43/44/45/46. Any time you promote rules that add to the transparency of option markets; you are going to instill confidence into the market place. Any cost to improve trade would be much better than PFOF. Let everyone who wants to take risks be able to do so at the same level.
The challenges that lie ahead are based in transparent and seamless order execution for all who understand and are willing to take risks. Take the ambiguity and the shadowy nature of all PFOF out of the trading business. Instill confidence by serving those who take and hedge risks.