April 16, 2004
AGS Specialist Partners
111 Broadway 4th Floor
New York, NY 10006
April 15, 2004
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: SEC Concept Release 34-49175, File No. S7-07-04
Dear Mr. Katz:
We at AGS Specialist Partners welcome the opportunity to offer the Commission our perspective on the recent competitive developments in the Options Industry. While at a glance, the industry is more competitive and efficient than it has ever been, a more thorough examination reveals several fundamental problems that threaten the very integrity of the system. We applaud the Commissions decision to investigate and hopefully solve these problems, though we feel that SEC action is long overdue. Internalization of customer order flow and payment for order flow are despicable practices that will never benefit the customer. It is appalling that these abhorrent practices still exist in the US securities markets an astounding flaw in the crown jewel of the global economy. These grossly anti-competitive practices operate solely to increase the profitability of select market participants at the expense of both market stability and customer welfare. We are glad to have the opportunity to provide you with our input on the matter, but an inquiry is not enough. Now is the time for action, and the options markets are in desperate need of swift and sweeping Commission intervention.
Head Options Specialist
AGS Specialist Partners
Response to SEC Concept Release: Competitive Developments in the Options Markets
AGS Specialist Partners
Marc Liu, Head Options Specialist
Ben Phillips, Options Specialist
Michael Ashley, Options Specialist
Question 1. To what extent, if any, does payment for order flow in the options markets affect a specialists or market makers incentive to quote aggressively?
There is no incentive for a market maker to quote aggressively in a trading environment corrupted by payment for order flow PFOF. Market makers MMs are most aggressive when they are fighting for order flow. Fidelity is an order flow provider that refuses to receive PFOF. They route their orders based on the relative performance of the various exchanges, thus giving MMs and specialists the incentive to quote as aggressively as possible. When order flow is earned through better execution, customers are rewarded with tighter spreads and the efficiency of the marketplace is improved. When order flow is guaranteed through cash payments or through other means of bribery, customers suffer as spreads widen and the marketplace becomes less efficient. Prepaid order flow, if anything, gives MMs an incentive to widen their quotes as order flow is guaranteed regardless of performance. Rather than making markets as narrow as possible to attract customers orders, MMs make their quotes as wide as they can get away with, without repelling the customer.
The commission should also be aware of another, even more insidious development in the world of PFOF. Order routing agreements involve a firm which may or may not be the Specialist/DPM/LMM in that option paying brokerage for the opportunity to see an order before it hits the market and then routing it to the exchange of their choice. Using this free look, depending on the specifics of the agreement, they have the opportunity to submit a solicited contra-order or a guarantee of participation on the other side of the original order. These guarantees can be overt, implied, or perhaps worse established by gaming the current exchanges rules, which are not designed to regulate these practices. These deals straddle the line between PFOF and internalization and end up providing the worst of both worlds with respect to customers interests over the long run.
Question 2. If commenters believe that payment for order flow diminishes a specialists or market makers incentives to quote aggressively, why have spreads narrowed over the past few years while payment for order flow increased?
At any level, the existence of PFOF will widen spreads. It is the effect of other market factors that has led to both the tightening of spreads and the increase in PFOF over the past few years. As more options are listed on multiple exchanges, competition escalates exponentially. Markets tighten and PFOF increases as each exchange fights for a bigger share of the order flow. Additionally, new and better trading models have seen more widespread use, facilitating more accurate pricing, dispersion trading and alternative methods of hedging risk. Armed with improved technology and lower trading costs i.e. seat leases, exchange fees, etc., MMs are more willing to compete, tightening spreads and providing customers with better fills.
Question 3. Where multiple market participants can quote independently and incoming orders are allocated to the market participant that sets the best quote, are market participants more or less likely to enter payment for order flow arrangements than those on markets with less intramarket quote competition?
Less intra-market quote competition will make it more likely for market participants to enter PFOF arrangements. MMs are more likely to pay for order flow if they are guaranteed to receive a greater percentage of the order flow. More intra-market competition reduces the chance that MMs entered in PFOF arrangements will actually participate on those orders for which they have paid. PFOF reduces the incentive for both intra-market and inter-market competition.
Question 4. Do current exchange rules guaranteeing specialists a certain portion of orders affect quote competition? To what extent is intramarket quote competition preserved by requiring that non-specialist market makers be permitted to compete for at least 60 of an order without bettering the specialists quote? Is the harm to quote competition, if any, decreased on those markets that permit market makers to auto-quote?
Specialist guarantees are essential to the structure of the specialist system. Specialists provide depth, continuity and liquidity in the marketplace. They are responsible for every bid and offer on every strike in every product that they trade at all times. Non-specialist MMs can pick and choose when and where they want to trade. Furthermore, they are subject to virtually no regulatory liability relative to that of the specialist. Specialists take on much more risk than non-specialist MMs and the only incentive to them to do so is the guarantee that they will have the opportunity to trade with a greater percentage of the order flow. Our current system provides strong competition and liquidity for more liquid, easier-to-trade products. Certainly, the specialist guarantees currently in place have not prevented the development of tremendous market quality in the QQQ option however, in riskier, more-thinly traded issues, it is of paramount importance that there is an entity who is responsible for all markets and the quality of the customer fills provided in those markets. Market participants picking and choosing which trades they want to be involved in, without any responsibility to provide continuous liquidity and/or reasonable, two-sided markets in all series, is a recipe for liquidity disaster at the precise moment when liquidity is most needed. The only incentive for a MM to be responsible to a higher standard, taking on risk and responsibility on every trade, is a guarantee of greater participation on every trade.
Intra-market quote competition is not only preserved in a product where the specialist is guaranteed percentage of the order flow, it is improved. This guarantee should not be affected when a percentage of the order flow is internalized. Should an order come to the floor and 40 of it is internalized, the 40/60 split between specialist and non-specialist MMs should be maintained on the balance of the order, not on the original quantity i.e. if 1000 contracts trade and 400 are taken down by the firm, the specialist should still be entitled to 40 of the balance, or 240 contracts.
Under the specialist system, auto-quoting MMs are driven to be more aggressive than they would be in an environment where there is no one responsible to the markets, since they are forced to compete with someone meeting a higher standard. Without a specialist, they could be as wide or as passive as they want, their only incentive to be the best of a bad lot.
Question 5. Is a market makers incentive to quote aggressively impacted by the percentage of orders that an upstairs firm can internalize? For example, all things being equal, is a market maker less likely to quote aggressively if exchange rules or customs permit an upstairs firm to internalize a substantial portion of each order that it brings to the exchange?
Internalization of order flow is the most detrimental force to the stability and the efficiency of the options marketplace today. It is tantamount to the illegal practice of insider trading. When firms internalize an order, they are acting as principal on one side of the order and agent on the other. This is a clear-cut conflict of interest. MMs are robbed of their incentive to quote aggressively by internalization. The auction designed to find the best price for the customer ends up working in reverse. The firm searches for the worst price for the customer at which it can internalize the largest percentage of the order. Firms will rarely internalize bad orders, thus the MMs absorb 100 of the bad orders while having access to a much smaller percentage of the good ones. Rather than quote aggressively and be at risk of getting picked-off, MMs widen quotes and wait to trade the balance or scraps of orders that firms only partially internalize. Customer orders face a wider spread to begin with and are never subject to price improvement as the price is already set before the order even hits the floor.
Question 6. Do customer orders that are routed pursuant to payment for order flow arrangements ever receive less favorable executions than orders not subject to such arrangements? To what extent do exchanges rules requiring that members avoid trading through better prices on other exchanges ensure that any order, regardless of the reason for its being routed to a particular exchange, receives at least the best published quotation price?
All orders receive less favorable executions as long as PFOF exists. PFOF creates an anti-competitive environment where the impetus to give favorable executions to orders is non-existent. Market participants are blind to the origin of an order i.e. whether it is routed pursuant to PFOF or not so regardless of origin, in a market where PFOF is allowed, all orders are destined to receive unfavorable execution. Regardless of whether or not PFOF exists, the current rule structure in place amongst the exchanges does a satisfactory job of ensuring that the majority of orders are executed at least at the NBBO. Although complex orders spreads, orders tied to stock, etc. and relaxed sold sale regulations make it possible for orders to trade through the NBBO, this is the exception and not the rule.
Question 7. Do market makers establish the price and size of their public quote based on the assumption that they may trade with an informed professional, which involves more risk than trading with an uninformed non-professional?
One of the inherent risks in market making is the firm-quote rule. Posted markets are supposed to be honored for both uninformed non-professionals and informed professionals. Assuming that the orders of informed professionals represent riskier trades, it would behoove MMs to establish their quotes with the risk of those trades in mind.
Question 8. If commenters agree that public quotes are based on the assumption that the market maker may trade with a professional, are such quotes wider than they would be if market makers only received uninformed, non-professional orders?
Although the presence of professional orders may factor into the public quote, it is the presence of insider order flow that dictates the minimum width and maximum size. In this market, there is so much information out there that the line between professional and non-professional order flow has been blurred however, regardless of regulation, there are always going to be orders that are based on knowledge that is not public. Taking advantage of unforeseen, news-related stock moves, dividend changes or some other form of insider information, these orders almost always represent the most pre-hedge risk from the perspective of a MM. Insider orders are the primary reason why the public quote does not always represent the best market.
Question 9. Are market makers willing to trade with non-professional orders at prices better than their quote?
MMs are often willing to trade with non-professional and professional orders inside of their markets. PFOF, internalization, the firm-quote rule and the presence of insider order flow pressures MMs into showing what they are comfortable doing, rather than what they want to do. In a product where the specialist is a dime to twenty cents wide depending on the price of the individual option and is showing a bid and offer for 250 contracts on every strike, he/she is at tremendous risk should multiple orders come in at the same time all over the board however, should one quote/order come in on one particular strike, the specialist might improve upon his/her market to outbid the away markets, attract future orders or maybe to increase his/her participation where there is greater intra-market competition.
Question 10. If the Commission were to eliminate payment for order flow would non-professional orders get better prices?
All orders, regardless of status, would receive better prices following the elimination of PFOF for the reasons stated above for example, see question #1, but nearly any of the questions would apply.
Question 11. Do customer orders that are internalized in whole or in part on an exchange receive less favorable executions than orders that are not internalized? If so, why?
The existence of internalization ensures that all customer orders will receive less favorable executions than they would should the practice of internalization be abolished. Internalization, at its roots, is a conflict of interest. Firms rarely internalize orders that they do not find favorable. In some cases, a firm will trade with their customer order to provide liquidity at prices or sizes not available in the marketplace. While this is clearly in the customers best interest, this form of internalization, it is unfortunately the exception, not the rule. The vast majority of the time, firms internalize orders by trading with their customers at prices where there is adequate market liquidity to fill the order outside of the firm. In these cases, the firm is not interested in finding the best price for the customer, but rather in finding the market center that will allow the firm to internalize the largest percentage of the order. In many cases, the firm will simply direct this order to the least liquid, least competitive marketplace. In more egregious cases, the firm will quote the market on different exchanges, saying things like I have a 2 bid for 1000, but only if I can sell 800 for the firm. The MMs on that exchange are then given the choice of either allowing the firm to internalize 80 of the order or having the firm cancel the order and trade it on another exchange where they know they can trade it their way. As this pattern repeats itself, the firm may decide that the MMs on the initial exchange are uncooperative too competitive? and stop bringing orders to that exchange entirely. This type of behavior causes direct harm to the customer. The order is being directed in this case away from a more competitive, liquid exchange based on the firms interest, not the customers, a perfect illustration of one of the conflicts of interest inherent in firm internalization.
Any liquidity the firm is willing to provide over and above the available market liquidity will follow an order to any exchange. If the firm which already has a leg up on other market participants as they will receive a commission on every order is willing to fill the customer at more aggressive prices than any exchange, then the customers interests are served, and the firms desire to internalize the order is not an issue. Internalizing the order at any price where sufficient liquidity exists in the marketplace supplants the focus from the customers interests to those of the firm. When the firm has its own best interest in mind, there is no more incentive for the firm to seek the market center that will provide the best price for the customer. Rather than seeking a market center that might improve the customers fill, the firm will actively avoid that market center in order to better facilitate internalization.
An NBBO fill may or may not be the best price available for the customer. If the firm were to improve price from the NBBO slightly by as little as a penny?, then it is more than possible that they have disingenuously substituted price improvement for an attempt to actually seek out the best price for the customer. If the firm were really providing the best price available, then there should not be any issue with checking the order in the other marketplaces. Some firms might argue that this might take longer and thus hurt the customer, but you should remember that these are the same firms willing to take the time to shop an order between exchanges, looking for the least competitive exchange so as to internalize more of the order. Why should it be acceptable to delay a customers execution to suit the interests of the firm, but not to suit the interests of the customer?
Question 12. Do exchange rules requiring that an auction occur prior to a trade ensure that internalized orders are executed at the best available price?
Internalized orders are rarely executed at the best available price. The nature of internalization forces markets to be wider than they would normally be. MMs have access to a limited amount of the order flow. On the order flow they do see, they are bullied into showing wider and smaller markets fearing that if they show their best or get in the firms way by showing a tight market with good size, it will scare the order flow away to a less competitive exchange.
In the previous question we raised issues regarding the idea of fractional price improvement and how it doesnt always represent a best effort by the firm on behalf of their customer. We must be very careful not to assume that having a process that purportedly aims to protect the customer automatically ensures that a customer is best protected. For example, the PIP auction on the BOX offers customers price improvement does this mean that customers automatically receive the best price available? Of course not. It could very easily be used by a firm that wishes to internalize an order by providing minimal price improvement while sidestepping any requirement to attempt to find a better price .05 or .10 better, perhaps elsewhere in the marketplace. On any execution report, the customer is not informed that the firm acted out of its own interest and avoided trying to save the customer a nickel, but is rather told that they received price improvement of one penny. A lie with the appearance of truth is, in the long term, often more harmful that an outright lie.
Conflicts between the Roles of Market and SRO
Question 13. Is an SROs enforcement of its members best execution obligation affected by the SROs interest in attracting and retaining order flow from those same members?
The SROs interest is its own. The members and the SRO are both best served in the long run through the SRO strictly enforcing the members best execution obligations in order to maintain the integrity of the SRO and its members in the eyes of the customers. There should, however, be some framework through which the SROs work together to ensure that best execution obligations are upheld through the marketplace. The SEC should also work hard to ensure that all exchanges meet a certain minimum in terms of rules and rule enforcement. There is a danger that the more influential firms might be able to shop between exchanges for the one that is the most desperate, and thus the most willing to allow the firm to play fast and loose with the rules.
Question 14. To what extent do payment for order flow practices generally, or exchange-sponsored payment for order flow specifically, exacerbate the conflict an SRO has in carrying out its obligation to enforce its members best execution obligation?
Without paying for order flow, an SRO must rely on its integrity and history in giving customers the best executions possible. If an exchange can be assured of order flow through the payment of bribes to brokerage houses, it need worry less about its history of enforcement. It is inconsistent to accuse the SROs of failing to uphold their obligation to the customer while completely overlooking the fiduciary responsibility that the broker routing an order to an inferior marketplace for payment has to the customer.
Question 15. Does exchange-sponsored payment for order flow affect specialists or market makers incentives to quote aggressively differently than other types of payment for order flow? If so, in what respects?
All PFOF diminishes the incentive of a MM to quote aggressively. The abolishment of Exchange-Sponsored PFOF would unfairly advantage exchanges with fewer participants without solving the problem.
Question 16. What safeguards, if any, should an options exchange have in place to ensure that it can carry out its regulatory responsibilities with respect to those of its members that accept payment for order flow or internalize trades? For example, would an independent SRO to oversee how brokers meet their best execution obligations be feasible and desirable?
PFOF and internalization should be banned. If both practices are banned, then there would be no need for additional regulatory enforcement however, if they are not banned, the exchanges should be equipped with the power to better monitor off-floor firms and brokerages, ensuring that they carry out their responsibilities. As of now, any exchange who is disenfranchised by a trade that happens on another exchange has no recourse other than to ask that exchange that printed the trade to investigate. Obviously, if an exchanges compliance department was overworked, or lax in policing, firms doing questionable trades would gravitate to that exchange. Allowing the SROs to work together to police some of these off-floor firms, rather than leaving it to each exchange individually, would definitely help provide better and more consistent regulation.
Should the Commission Take Action at this Point?
Question 17. Do recent regulatory changes together with competitive forces in the options markets make additional regulatory action at this time unnecessary?
Additional regulation is necessary because the rules that are in place now have proven ineffective in curbing the continuing trend in which firms internalize a higher percentage of their order flow at the expense of their customers. PFOF and internalization cause conflicts of interest within order flow providing firms that have not been addressed by recent regulation in the options market. Unless the Commission takes immediate action against PFOF and internalization, firms will continue to sidestep the ineffective and inconsistent rules we have in place. The SEC needs to act on behalf of the customer to avoid a race to the bottom among fragmented and desperate exchanges. Change of a drastic nature is required to preserve the integrity of our markets.
Question 18. What would be the likely consequences to the options markets in terms of competition and execution quality should the Commission decide to take no regulatory action at this time? Specifically, do commenters believe that the current trend toward narrower spreads in the options markets could itself eliminate payment for order flow, specialist guarantees, and internalization?
The current trend toward narrower spreads will cease and reverse if the Commission decides to take no action at this time. Narrower spreads are not eliminating PFOF. PFOF is not causing spreads to narrow. If the Commission does not ban PFOF, the incentive to quote aggressively will disappear. Soft-dollar PFOF and internalization will drive smaller players, unable to compete in such arenas, out of the market, limiting competition and widening spreads in the long run. If the Commission allows things to continue unchanged, all of the competitive gains over the last couple of years will eventually evaporate, and the customer will be the biggest loser in the end.
Should the Commission Require Brokers to Rebate All or a Portion of Payments They Receive?
Question 19. Should brokers that receive payment for order flow be required to rebate all or a certain portion of those payments to their customers or demonstrate that the economic benefit of payment for order flow has been passed on to customers? If so, how should the amount of any such rebate be determined, and how would a firm demonstrate that it passed the payment for order flow benefit to customers?
All payments received by brokers for their order flow should be passed on in their entirety to the customer. However, there is no realistic way to monitor or enforce such a policy, another reason why PFOF should be banned altogether. The discount that customers would receive in the form of their rebate from PFOF would be analogous to the miniscule price improvement associated with internalization. Yes, the customer would be receiving a better price after rebate, but more often than not, this price would be much worse than the price they would receive, had their order been routed based on competition and performance, rather than PFOF.
Question 20. How would any non-cash inducements to route order flow be valued for purposes of any such rebate?
PFOF in all forms should be banned. Non-cash inducements are murkier, harder to trace and impossible to pass on to the customer.
Should the Commission Ban Payment for Order Flow, Specialist Guarantees, and Internalization?
Question 21. What would be the effect of banning all payment for order flow arrangements in the options markets? If the Commission determined that a ban on payment for order flow were warranted, would a ban only on cash payments be sufficient or would non-cash inducements also have to be banned? If commenters believe that the Commission should impose such a ban, could such a ban be easily evaded in light of the numerous forms that payment for order flow arrangements can take?
Banning all PFOF arrangements is not an option, but rather a necessity. Under current practices, order flow is driven away from the more competitive exchanges to those that pay the most for it, regardless of performance. Eliminating PFOF will level the playing field amongst the exchanges. Furthermore, it will tighten spreads as built-in costs for firms that are currently engaged in PFOF arrangements are reduced.
Non-cash inducements affect the market in the exact same manner as cash payments for order flow. The elimination of cash payments without a corresponding abolishment of non-cash inducements might actually exacerbate the situation. Firms that have no non-cash inducements to offer order flow providers would be forced out of the competition. Some would argue that an outright ban on all forms of PFOF is not practical because of the many, sometimes, sinister forms that PFOF can take. If the Commission were to abolish PFOF in all forms, Im sure that some firms would continue to bribe order flow providers in less-detectable ways, but they would be breaking the law. The Commission has a history of taking a strong stance on such potentially murky issues and this is another opportunity for the SEC to intervene and bring light to the darkest regions of the market. Heightened regulations and the threat of law-enforcement would more than likely curb such illegal practices and the options marketplace would become a healthier and more competitive environment. Ultimately, customers would benefit the most from tighter spreads and increased competition for order flow.
Question 22. If the Commission were to ban all payment for order flow, but continue to permit firms to internalize their customers orders, would it provide an unfair advantage to integrated firms that have customer order flow they can internalize? If a ban on payment for order flow unfairly advantaged integrated firms with broker and dealer operations, should the Commission revisit the issue of whether firms should be permitted to operate both as a broker and as a dealer for customer options orders?
Integrated firms that have customer order flow they can internalize would be greatly advantaged by the elimination of PFOF if the practices of internalization, facilitation and solicitation were not also abolished. Brokers should not be allowed to operate as both principal and agent due to the inherent conflict of interest.
Question 23. Should the Commission ban some or all specialist guarantees and internalization i.e., dealer participation arrangements in the options markets? Should any such ban only be done in conjunction with a ban on payment for order flow?
Specialist guarantees and firm internalization are completely different and affect competition in the market in diametrically opposite ways. Specialist guarantees as discussed in the answer to question #4 above are incentives to specialists to provide continuity and liquidity in the marketplace. It allows them to make tighter markets and take on greater risk, both immediately benefiting the customer. Internalization in no way ever benefits the customer. Firms, without any direct responsibility to market liquidity, can pick and choose the orders they internalize in much the same way non-specialist MMs can and thus, should for no reason be entitled to any sort of participation-guarantee incentives. Firm participation guarantees that there is one less party competing for a share of the customers order, the firm itself. The good kind of facilitation, where a firm fills the order at a price better than any that the marketplace is unwilling to offer, is severely discouraged when the firm is guaranteed participation at a price worse for the customer, even if the marketplace has already offered to the fill the customer at said price.
Although it would be most beneficial to the market and to the customer if both internalization and PFOF were banned, one being abolished should most certainly not be a prerequisite for the elimination of the other.
Question 24. What would be the impact, if any, on competition in the options markets if the Commission were to ban either payment for order flow or dealer participation arrangements without banning the other type of arrangement?
Banning PFOF without banning internalization would unfairly advantage firms that internalize their own order flow to the disadvantage of the customer. If PFOF shows us that each order has a value, then the brokerages would simply work to find another way to capture that value. It is not hard to imagine a tremendous increase in the number of orders internalized, as firms no longer able to profit through PFOF attempt to monetize order flow through internalization.
Eliminating internalization without abolishing PFOF would unfairly favor the larger firms over the smaller and independent MMs who cannot pay for order flow. The order flow would be directed to the firms most able to pay for it, eliminating their incentive to quote aggressively. Outlawing PFOF without outlawing internalization would also lead to an increase in solicitation. Firms would use the same tactics, same loopholes, and same anti-competitive behavior to receive commissions for directing their order flow to the least competitive marketplaces, where their solicited clients could take the other side of the customers order.
If each order is worth something, wouldnt it be best to have the exchanges compete for that valuable order on their merits, so that value is delivered to the customer, rather than to the firm?
Question 25. What would be the impact of a complete ban on all such practices? For example, if the Commission banned payment for order flow and dealer participation arrangements, who would benefit? Would specialists and market makers quote better prices? Would they retain the economic benefit they now share with order entry firms? What effect would a ban have on non-dominant markets or firms seeking to attract order flow from the dominant market participants?
A complete ban on PFOF and internalization would immediately benefit the options market by making performance the deciding factor in where order flow is routed. Intra-market and inter-market competition would be greatly enhanced, effective spreads would tighten and every order would be subject to the best possible execution.
Again -- if each order is worth something, wouldnt it be best to have the exchanges compete for that valuable order on their merits, so that value is delivered to the customer, rather than to the firm?
Question 26. In response to a recent request for the views of the options markets on payment for order flow arrangements, one of the markets stated that the Commissions review of payment for order flow and internalization should not be limited to the options markets but rather should include the equities markets as well.94 Are there differences between the equities and options markets that warrant different treatment? If so, what are those differences? If different treatment is not warranted, should the Commission consider a market-wide ban on payment for order flow and dealer participation arrangements?
There is no difference between any markets when it comes to the effect of PFOF. The question omits mention of ETFs, a market which bears as many similarities to the option markets as it does the equity markets. It makes no sense to choose which markets should allow customers to be disadvantaged, and which markets should protect them. PFOF is anti-competitive and is never in the best interest of the investing public. The Commission should institute a market-wide ban on PFOF and internalization. Would it make sense to ban kickbacks and back-room deals in the new car market, but not in the used car market?
Should the Commission Ban Only Exchange-Sponsored Payment for Order Flow?
Question 27. What would be the effect on the options markets and market participants if the Commission were to restrict only those payment for order flow arrangements that are sponsored or sanctioned in some way by a registered options exchange, as Phlx has proposed in its petition? In particular, would such a restriction favor a specialist that can be assured of trading with the largest proportion of order flow routed to its exchange? In other words, would such a ban unfairly disadvantage an exchange on which market makers compete more aggressively with the specialist?
Payment for order flow is wrong in all forms. Whether the payments are exchange sponsored or individually administered the result is the eventual undoing of the auction markets. Eliminating only exchange-sponsored PFOF benefits exchanges with less competition and less participants. It could also lead to more fragmentation as larger market participants might endeavor to start their own exchanges to ensure a larger portion of the order for which they have paid.
Question 28. Would banning exchange-sponsored programs, while continuing to permit other types of payment for order flow and dealer participation arrangements, address the concerns discussed above regarding wider spreads, best execution, and SRO conflicts of interest?
Eliminating exchange-sponsored PFOF without abolishing other forms of PFOF individual and soft dollar would unfairly favor the larger firms over the smaller and independent MMs who cannot pay for order flow. Exchanges would essentially be punished for having a diverse pool of capital, made up of many liquidity-providing participants, making it impossible to have aggressive intra-exchange competition. The order flow would be directed to the firms most able to pay for it, on the exchanges with the least competition, eliminating their incentive to quote aggressively. Spreads would widen and customers would be disenfranchised out of the best possible execution for their orders.
Should the Commission Establish Uniform Rules and Enforcement Standards Regarding Internalization and Specialist Guarantees?
Question 29. Should the Commission take action, as CBOE recommends, to prohibit a broker from internalizing all or part of its customers orders if those orders have not first been exposed to the market in a manner that provides what CBOE terms a meaningful opportunity for price improvement? What would constitute a meaningful opportunity for price improvement?
If an order is not first exposed to the marketplace and given a meaningful opportunity for price improvement, the customer will never be guaranteed the best possible price of execution. A meaningful opportunity is a reasonable amount of time for market participants to evaluate an order and respond with their best market, perhaps 15-30 seconds. If orders are initially exposed to the auction marketplace rather than shopped around to upstairs firms for hours beforehand, price discovery will be optimized and order front-running will be greatly reduced, if not eliminated, again, to the benefit of the investing public. The Commission should be careful to ensure that a meaningful opportunity is provided, because having a mechanism to provide price improvement without that meaningful opportunity would act as a rubberstamp excusing anti-competitive behavior while providing the illusion of a competitive fill. Allowing markets to price improve in increments small than the minimum quote increment has a similar effect. MMs should be given a meaningful opportunity to provide meaningful price improvement.
Question 30. Do the options exchanges current rules requiring that an order first be exposed to an auction before a firm can internalize it provide a meaningful opportunity for price improvement?
Internalization greatly reduces the effectiveness of the auction system. A firm will shop an order on all floors and then execute the order on the floor, which provides the least liquidity, thus allowing the firm to internalize the highest percentage of the order. Firms are not satisfied with 40 of an order as the rule states and instead will feel out the market by asking questions such as, How many would you do at 1.00 and how many at 1.05? and then take the order to the least competitive exchange. The purpose of an auction market is to get the fairest price for the customer by fostering competition amongst the participants. Internalization achieves the opposite goal by punishing the most competitive MMs. Firms should be allowed to do more than 40 ONLY when no MMs are willing to and they are therefore serving a purpose to their customer. They should NOT be able to do 100 on one exchange when there are willing participants on another.
Question 31. What improvements could be made to the current framework for cross-market surveillance in the options markets to improve the ability of SROs to bring a best execution case against a broker that presents an order to be facilitated on one market and cancels that order, later executing it at an inferior price on another market?
The abolishment of PFOF and internalization/facilitation/solicitation eliminates the only possible motivation a broker would ever have to ever take an order away and facilitate it at an inferior price. Without the elimination of these destabilizing, anti-competitive practices, the current framework for cross-market surveillance has no method for dealing with a broker who cheats his/her customers out of their best executions, and insufficient tools for prosecuting such offenses. The raison detre of a broker is to get his/her customer the best price on an order. If a broker intentionally fails to do so for his/her own benefit, they should be suspended and should be forced to make restitution to both sides. There must be greater transparency and communication amongst the many exchanges in order to facilitate better cross-market surveillance of broker activity.
Question 32. Are there other practices, occurring frequently with respect to facilitation guarantees that are inconsistent with best execution obligations? For example, are there circumstances under which an upstairs firm should not be permitted to shop an order it is seeking to facilitate at more than one exchange to determine where it can get the most favorable terms for that order?
When a firm shops an order on several different floors, it is often searching to find the marketplace that will provide the least liquidity. This allows the firm to internalize a larger percentage of the order. Firms also engage in similar behavior when attempting to bill solicited parties for taking the other side of a customer order. The result of this process is not only are MMs not rewarded for making aggressive, competitive markets, they are actually punished. Making a tight market with good size will in reality scare an order to a less competitive exchange, a situation that inevitably results in the markets widening which, of course, hurts the customer. Firms should not be allowed to shop orders. If an order is shown to one floor and that floor makes a market with sufficient size to fill the order, that order should not be allowed to trade on that bid or offer on another exchange. This will encourage market makers to show their best hand and will result in faster, better executions for the customers.
Another practice that, unfortunately, is fairly common these days is for the solicitation and internalization to exempt some parties from a competitive auction. It is not uncommon for the firm and its solicited parties to be willing to sell at 1.95 to a customer, but to bring the order down asking if the firm can cross a given percentage at 2.00. If the exchange MMs allow the firm this percentage, then the customer will pay the higher price, even though the order could have been filled at the lower price. The only time the customer would receive the better price is when the MMs on whichever exchanges the order is shopped to will not allow the firm that percentage at the higher price. Of course, this means that the MMs wouldnt get to sell at the higher price, so as these practices go on, there is less and less incentive for them to try and compete with the firm. Internalizing firms and broker-solicited dealers are often allowed the benefits of behavior that in all other instances would be termed collusive. With foreknowledge of the exact terms of the order, they can trade ahead of the customer in the underlying, and then fill the customer at a worse price. Additionally, a firm or even a solicited party, is often allowed to give an order to sell the last 500 out of an order totaling 5000 contracts. If a specialist were to tell a MM in the crowd that regardless of price, that MM was allowed to sell the last 500 contract of a larger order, especially if given financial consideration by the MM, they would both go to jail. Brokers will often show only part of an order, the rest being kept upstairs or in the booth, to be crossed if and when the first part is filled. These orders are often given without prices, under the theory that prices will improve for the solicited party after the liquidity in the marketplace at the initial prices has been exhausted by the first part of the order. This effectively removes at least one market participant from having to compete for that order. They know they will get to trade with the customer at the best price for them worst for the customer, so they do not need to compete with the exchange MMs to improve the price for the customer. The Commission can no longer allow firm and solicited traders to trade like this. At the expense of the customer, firms are assured more profit with no risk or liability. Solicited parties receive a free ride, again, at the expense of the customer. The additional profits for the solicited parties are ensured through the payment of commissions to the broker or firm handling the customer order. Can you imagine an exchange MM in the trading crowd offering a floor-broker cash for receiving similar privileges? Why are these behaviors, so glaring and unbelievably illegal in one context, perfectly allowable in the next?
Question 33. Are the options exchanges rules with respect to facilitation guarantees and the application of those rules consistent regarding which conduct should and should not be permitted?
The at least 40 rule, rather than acting as a standard, acts as a baseline where the firm will only take the order where they know they can do the greatest amount over 40. The rules, in their current format, are ineffective. Brokers often invoke this rule, whether by deception/omission, or through active threats, for solicited parties as well. Specialist and non-specialist MMs are afraid to disallow this sort of behavior, because they know that should the firm shop the order, chances are, at least one exchange out of the six will allow the trade to happen under those terms. If facilitation/internalization/solicitation is eliminated, then these rules become unnecessary.
Should the Commission Apply Rule 11Ac1-5 to Options?
Question 34. Would Rule 11Ac1-5 data be useful to firms routing customers options orders to exchanges and to those customers?
Anything that assists brokers in sending orders to the most competitive markets those showing the tightest bid and offer will improve the execution of customer orders. Of course, the rules could possibly be better adapted. For example, in the presence of PFOF and internalization, effective spread is not the best measure of market competition as the posted markets often do not represent the best bid and offer.
Question 35. If Rule 11Ac1-5 data would be useful for options orders, what adjustments, if any, would options market centers need to make to calculate and disseminate Rule 11Ac1-5 statistics? For example, is the OPRA NBBO a sufficient measure to enable market centers to make the Rule 11Ac1-5 calculations that require a consolidated BBO? If not, what changes would need to be made to the OPRA NBBO to make it suitable for such calculations?
The NBBO in its current format is quite easily identifiable. The only change that could possibly improve on this format is to make the firms more easily identifiable when they take the other side of customer trades. Perhaps there should be a greater disclosure of or a higher level of disclosure in the interest of deterring the internalization of customer orders for the sake of disenfranchising the marketplace.
Question 36. Are there other reasons why Rule 11Ac1-5 should not be applied to the options markets? For example, do the anticipated benefits of having better execution quality information for the respective options market centers justify the costs that the market centers would incur in calculating and disseminating the Rule 11Ac1-5 statistics?
More disclosure as to how orders are handled is always better however, we should be careful not to let fine print, separate reports and piles of often Byzantine data replace a real commitment to ensuring that all customers receive the best possible executions. Making this data available is a good first step, but simply disclosing data, often in a confusing context, should not absolve a firm from doing the right thing. Most customers will not read or pay meaningful attention to such reports and certainly might not understand the implications of all the data presented. Please do not allow this soft gesture at disclosure replace strong action by the Commission towards protecting the interest of the customer.
Would Penny Quotes in Options Reduce Payment for Order Flow?
Question 37. If options were quoted in penny increments, would payment for order flow in the options markets cease or be diminished?
The only thing that would cease or diminish PFOF in the options markets would be if the SEC were to ban or restrict PFOF. The adaptation of penny increments would have no foreseeable effect on PFOF.
Question 38. Would a move to penny quoting in the options markets place an undue strain on existing system capacity? If so, which market participants would be most negatively impacted e.g., broker-dealers, exchanges, vendors?
Systems capacity should never stand in the way of progress. If the benefits were there, the Commission could establish a realistic timetable for penny quoting. However, the benefits are not there, and the nature of derivative markets ensures that penny quoting would cause an unbelievable explosion in quote traffic. Even OPRA itself has had capacity issues, and this is without multiple auto-quoting participants on all exchanges, in all options. Any negative impact will likely be shared amongst all the parties involved, making the move illogical, especially since quoting in pennies would most likely affect customers negatively as well. The Commission should understand, however, that quoting in increments larger than the minimum trade increment is horrible for market structure. For example, quoting in nickels and dimes but trading in pennies, or 2.5 cent increments hurts customers by decreasing transparency and fostering internalization.
Question 39. If so, are there ways to alleviate potential strains on system capacity to allow the options markets to begin quoting in penny increments?
Adequate technology must be available before any major change in the quoting structure of the options market takes place.
Question 40. Are there other issues that make a move to penny quoting in the options markets infeasible or inadvisable? For example, what would be the impact on the rapidity of quote changes i.e., flickering quotes?
Penny quoting is not a viable solution for the options market. Too much power falls in the hands of order handlers who by their nature have pre-existing knowledge of customer limits. The customer is forced to show his/her hand to see the true depth and liquidity of the market hidden by the penny-wide mask. Penny increments will hurt the customer the most and help MMs and the firm. It will promote internalization because firms will be able to improve markets on smaller increments, and with knowledge of customer limits they will always do so only a penny better than they have to. This would make it nearly impossible for MMs to compete with internalization by quoting aggressively. Firms would be able to pick and choose which orders to fill, sweeping offers or bids until they got to that level, and then internalizing the balance. This can be destabilizing to the markets, as all participants are blind as to where the order might trade except for the firm. Transparency and depth of markets would be destroyed.
Price manipulation is a much bigger problem in a derivative product where there is a defined fair-value. Any customer limit order would be pennied by MMs until the order was worth filling. This would serve the dual purpose of hiding the customers order from the rest of the market, and front-running an order that might trade at a better price when the customer realizes that they need to send a market order. If the market moved against the MMs, and the penny-improved trades became losers, the MMs would close their trades, only losing a penny when they take out the customer. Quoting and trading in pennies will make MMs and firms more profitable at the expense of the customer. Market structure will be harmed as limit orders become a thing of the past and MMs and firms are able to penny customers and trade almost without risk by doing so. Guaranteed miniscule price improvement will prevail at the cost of real price improvement.
Question 41. If exchanges required brokers to pay directly for the capacity that they use, would the brokers quote more efficiently, and thereby make a move to penny pricing in the options markets more feasible?
Any increase in fees related to updating quotes will lead directly to less aggressive market making as MMs and brokers have to absorb the increase in fees into their costs. If a MMs cost were based on how many quotes they generated, firms would want to send less quotes. The tighter a quote is, the more quickly the MM sending it must adjust in order to avoid being picked off on a stale quote. If able to quote less, markets would widen and quotes would be less aggressive. Having to pay for quote capacity would also discourage firms from quoting some series, or even whole classes of options, especially those less liquid and less likely to trade, leading to an eventual liquidity drain in some of the markets which are already less liquid.
Paying directly for capacity would also prove an unfair advantage to firms that internalize, without sending quotes. Those firms not generating quotes would still be able to internalize trades without bearing the costs of quoting, resulting in wider and less responsive markets. The execution of customer orders would suffer greatly without the competitive benefit of aggressive MM interaction or pricing. Quoting costs would also act as an additional barrier to entry. Bigger firms would be less adversely affected by an increase as they could afford it better.
Should the Commission Apply the Limit Order Display rule to Options?
Question 42. Should the Commission apply a limit order display obligation to the options markets?
Absolutely. This obligation is already in practice on the AMEX.
Question 43. Would the benefits of a uniform display requirement justify the costs of imposing such an obligation on options market participants?
The current regulatory environment does a good job of ensuring that limit orders are displayed in a timely fashion. However, it is worth mentioning that the unfair advantage and corresponding customer disenfranchisement possessed by a MM who does not immediately show a limit order, is the same advantage possessed by a firm intending to internalize an order that it has not yet brought to the marketplace. They have knowledge of an order that is hidden to the rest of the market and can use that knowledge to their advantage. These practices will always be to the detriment of other market participants, the customer involved receiving the worst.
Question 44. Do the options markets have unique characteristics that would make the application of a uniform limit order display obligation there less feasible than in the equities markets? If so, what are those characteristics?
The derivative markets differ from the underlying markets in several important ways. The options markets, are, by definition, more fragmented, and thus have less liquid markets. This often makes it more likely for a customer to be able to receive price improvement. One could argue that where an order might receive price improvement, immediate, automatic display of a limit order does not give the specialist and/or MMs a meaningful opportunity to do so.
Question 45. If a limit order display obligation would be beneficial for the options markets, what modifications, if any, to Rule 11Ac1-4, would be required before it could be applied to options market participants?
In order to answer this question intelligently, we would need to have a more specific sense for how the limit order display obligation would be handled.
Question 46. If a uniform limit order display requirement is not appropriate for the options markets, are there other safeguards that could be put in place to ensure that customer limit orders are immediately displayed?
The current metrics assembled by the AMEX, and, I presume, the other exchanges, should give concrete data as to when and if customer orders bettering the market are displayed. If the current system is shown to be adequate, by said statistics, we see no special reason for additional safeguards. There should be consistent standards across all exchange for limit order display and execution quality data. Comparing apples to oranges doesnt make any sense.
We thank the Commission for the opportunity to express our perspective, and have a few items wed like to add.
The Commissions decision to investigate these matters is long overdue, and the best development in the options market it years. Payment-for-Order-Flow and Internalization are the two greatest threats to the viability of fair, liquid, competitive markets in the United States. However, we cannot state clearly enough that the behavior of Solicitation, whether by brokers or firms, performs in much the same way as both PFOF and Internalization, mixing the worst aspects of the two. Solicitation involves payment of commission to a party other than the customer, and often earns special treatment for the solicited party. They see the entire order, and its limit, are often given de-facto special participation rights and have no market liability, responsibility or risk. Why should those with the least responsibility get the best information, the best chance to participate and the best prices, and the ability to circumvent any exchange system based on priority/precedence? This liquidity is not responsible to the market. This so-called liquidity is often a drain on real market liquidity, in the same way that internalization can be, and should be addressed by the commission in the same way. Floor-brokers, off-floor-brokers, and firms all used solicitation as a revenue stream, often at the expense of on-floor liquidity and the customers themselves. The practice of solicitation is proof that any attempt to merely restrict internalization rather than ban it will be futile. By the letter of the law, solicited parties have no standing and no priority on any of the exchanges. In theory, they should not be able to participate on any trade in which exchange liquidity is sufficient. In practice, however, they are able to participate on nearly any trade they want, because it is in the best interest of order-handlers for them to participate, even if at the expense of the customers. In practice, orders are shopped around upstairs, without true price discovery, and then brought to the exchange where the solicited party can trade the largest percentage. The same threats and tactics are made, even though there is no rule guaranteeing participation. MMs are bullied into eventually making less competitive markets and picking up the scraps left over. Solicitation is basically a hybrid of PFOF and internalization.
To illustrate, imagine a situation where an option crowd on the AMEX offers 250 at 3.5, the best offer in the country. The broker pays 3.5 for 250, and the crowd raises their offer to 500 at 3.6. The broker then says he will pay 3.6 for 500, provided that his solicited party can sell half. The crowd resists, but is told that the trade will go up on the PHLX if they dont allow the solicited party to sell 250, so they finally relent. If the solicited party pays the broker a dollar a contract, or 1 cent on the option, to sell to a customer at 3.6, then the customer pays what he would have without the solicitation, the broker makes .01 a payment that does not go to the customer, and the solicited party effectively sells at 3.59. The crowd, having sold, on average, 500 at 3.55, is not rewarded for quoting aggressively, taking market risk, and providing continuous liquidity, while the solicited party received special treatment, and got to participate on a pick-and-choose basis, only at the better price of 3.59. Over time, this will destroy the incentive to quote aggressively, hurting market competition and the customer.
When considering the developments discussed in this concept release, we beseech the Commission to not be dissuaded from taking swift and market-wide action. Please dont allow fears of drastic change or difficulty of implementation to keep the Commission from doing what is right for the customer and for the markets. PFOF, internalization, and solicitation are anti-competitive, market-destabilizing practices that benefit the few at the cost of the many, most of all, the customer. They are practice that never should have been allowed. They are plagues upon our markets. If not already in place, by practice, they would never be allowed. If we lived in a world where they were prohibited, and this concept release were soliciting comments on whether they should be allowed, it would be laughable to consider the idea of adopting these practices into the options markets. It is bizarre that these behaviors are permitted in the most tightly-regulated industry in the world, but illegal in all other walks of like, seen as kickbacks and bribes.
SEC inaction on these issues makes it expensive for firms to do the right thing. SEC inaction helps to add to the skewed perception that these practices are acceptable and in the best interest of the markets. Firms that take their fiduciary responsibilities seriously, route their orders on performance, and without payment are disadvantaged when competing with firms that sell their customers orders to the highest bidder. Firms that avoid the conflict of interest inherent in internalization, and seek the best prices for their customer at all times are disadvantaged by SEC inaction. We implore you to take action and right these wrongs. The interest of the customer and the integrity of the options markets must not take a back seat to the Wall Street Greed.