111 Broadway, 10th Floor
New York, New York 10006
Fax (212) 346-7217
Chicago / Headquarters
175 W. Jackson, Suite 200
Chicago, Illinois 60604
Fax (312) 884-3050
220 Montgomery Street
San Francisco, California 94104
Fax (415) 291-8502
Web site: wolve.com
Web site: wolve.com
October 25, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
RE: File No. S7-17-00
Dear Mr. Katz:
Wolverine Trading, L.P. is a registered broker-dealer and a member of all United States options exchanges as well as the Chicago Board of Trade, Chicago Mercantile Exchange, Eurex and Xetra. Wolverine's sole business is proprietary trading. It acts as a specialist, DPM, or LMM on the CBOE, Amex, and PCX. Wolverine has more than 200 employees and is one of the five largest options trading firms in the United States. As such, the firm has a strong interest in and commitment to the fair and efficient operation of the securities and options markets and welcomes the opportunity to comment on the proposals in Release No. 34-43085 (the "Release") issued by Securities and Exchange Commission (the "Commission") on July 28, 2000.
We believe the Commission's proposal to amend Rule 11Ac1-1 (the "Quote Rule") and adopt new Rule 11Ac1-7 (the "Trade-Through Disclosure Rule") (the two proposed actions are collectively referred to as the "Proposal") will have far-reaching, adverse consequences for the development of a national market system for options. The interplay of the Proposal with the recently approved Options Intermarket Linkage Plan among the CBOE, Amex and ISE ("Linkage Plan") and the payment for order flow arrangements now in effect on all but one options exchange will (1) do nothing to improve the transparency of options execution quality; (2) inappropriately shift to market makers the responsibility for providing customers with best execution; (3) lessen the incentive for market makers to engage in price improvement; (4) lessen the incentive for customers to enter price improving limit orders; (5) encourage options order flow providers ("Brokers") to route customer orders based solely on the payments they receive from the options exchanges; and (6) continue the current, inefficient two-tiered options market in which customers and dealers are inappropriately differentiated.
In the remainder of this comment letter, Wolverine will explain its reasons for believing that the adoption of the Proposal will have these six undesirable consequences for public customers and the options market place. Wolverine will then offer suggestions for modifications in the Proposal designed to better assure achievement of the Commission's key objective of "encourag[ing] the removal of barriers to access, and the use of efficient vehicles to reach, better prices on another market."1
I. PROBLEMS WITH THE PROPOSAL
1. Fails to Improve Transparency of Options Execution Quality
The Commission states that a principal objective of the Release is "to provide customers with more information with which to evaluate the quality of executions achieved by their brokers...."2 This objective is to be realized through adoption of the Trade-Through Disclosure Rule under which a Broker would be required to disclose to a customer (a) each time the Broker routes an options order for that customer to an exchange where it is executed at a price inferior to a better published quote on another exchange (a "trade-through") and (b) the price of the better quote. Armed with this "important information," an individual investor purportedly would be "better able to actively monitor whether his or her order routing firm is fulfilling its best execution obligations."3
Wolverine agrees with Chairman Levitt's recent statement that "execution quality matters" and that the "shroud that currently surrounds execution quality leaves investors in the dark [and] undermines systemic competition."4 Unfortunately, the Proposal would leave that "shroud" securely in place. The only execution quality disclosures required by the Trade-Through Disclosure Rule would be with respect to customer orders executed on an options exchange that does not participate in an "effective national market system options linkage plan that includes provisions reasonably designed to limit intermarket trade through."5 The Linkage Plan is such an effective plan, and it is a foregone conclusion that the PCX and PHX will soon join the Linkage Plan or agree to one of their own. Since all options exchanges will subscribe to a linkage plan, Brokers will have no disclosure obligations with respect to options execution quality. Accordingly, the Proposal would do nothing to improve the "transparency of execution quality" that Chairman Levitt has so recently and correctly called for.6
2. Shifts Responsibility for Obtaining Best Execution to Market Makers
A second key objective of the Proposal is to "assist broker-dealers in evaluating and complying with their best execution obligations."7 Because "broker-dealers are increasingly required to regularly and rigorously evaluate the execution quality available at each options exchange," the Proposal is designed to "facilitate the ability of market participants to obtain the best price for customer orders...."8 The reality, in our view, will be quite the opposite. Under the Proposal, Brokers, for all practical purposes, would no longer have to make best execution evaluations, and the responsibility for obtaining best price for customer orders would shift from Brokers to market makers.
This shift will occur because of an unfortunate interplay between the Proposal and the Linkage Plan. First, as a result of the Proposal all options exchanges will be linked. Second, under the terms of the Linkage Plan, linked exchanges would be obligated to sanction their market makers that "trade-through better prices of other exchanges...." And third, as a result of the availability of the linkage and the threat of punishment for trade-throughs, the market makers (or more accurately, the specialist, DPM, or LMM) on an exchange not quoting the best price, would have a clear obligation on receipt of a customer's market order either to step up and fill the order at the better price or to send the order through the linkage to the exchange with the better price. In either case, simply by routing a customer order to a linked exchange - any linked exchange - the Broker would have fulfilled its responsibility for best execution, and the market makers on the receiving exchange would have become responsible for assuring that the order is executed at the best price. Such a reallocation of the responsibility for best execution turns fiduciary responsibility on its head.
It is the Broker that has the fiduciary responsibility to route customer orders to the best market. The Broker takes on this responsibility by acting as agent for execution of customer orders. To relieve Brokers of their obligation to route customer orders to the best market and to assure that those orders receive best execution after being so routed is in conflict with fundamental agency principles. Then to place the responsibility on market makers to provide best execution is without support in law or policy and is inappropriate, unfair, and economically unjustified. Rather than adopting the Proposal, the Commission should make clear that market makers acting as such have no obligation under Commission rule, exchange rule, or otherwise to step-up to a better price on another exchange or to route a customer order to another exchange quoting a better price.9
3. Decreases the Incentive for Market Makers to Engage in Price Improvement
The Commission has asserted that in making their order routing decisions Brokers must consider whether those orders are more likely to "receive a price that is better than the existing quotation (so-called `price improvement')" on one market rather than another.10 Thus even though Brokers may be routing their "packaged order flow" to a market not then quoting the best price, they may nevertheless fulfill their best execution responsibility if they have determined that by so doing they have maximized the "opportunities for obtaining improved executions."11
Given this obligation to seek price improvement, it might be argued that the Proposal does not relieve Brokers of their best execution obligation or allow them simply to route customer orders to the exchange of their choosing. In our view, however, the obligation to seek price improvement is unlikely to impose any practical constraints on Brokers' ability to batch route customer orders to any linked exchange they wish. An obligation to route customer orders to one exchange rather than another because of a greater likelihood of achieving price improvement there depends on the existence of meaningful differences among exchanges in price improvement opportunities. If there are to be such differences, there must be significant incentives for exchanges to engage in real price improvement, that is, publicly to quote better prices that are available to all market participants. But under the regulatory scheme the Commission is proposing, such incentives would not exist.
Consider the different consequences for market makers on an exchange that improves the NBBO and for market markers on an exchange that quotes prices wider than the NBBO. The exchange that improves the NBBO will not thereby increase its chances of attracting more orders, for an order sent to any other exchange will be assured of the same prices. Consequently, the market makers on the exchange quoting the better price will have taken on additional risk without gaining the prospect of additional financial reward. In contrast, an exchange that quotes prices wider than the NBBO will have the best of all worlds. It will not thereby diminish its attractiveness to order flow providers; its market makers will have reduced their risks; and the exchange quoting the better market may be induced to widen its quote, thereby allowing customer orders still to be filled at the NBBO, but at prices that are better for all market makers and worse for the public.
Without meaningful economic incentives to improve quoted prices - to engage in vigorous, systematic price competition -- the Proposal and the Linkage Plan would create a lose/lose situation for market makers on an exchange that improves the best price and a win/win situation for market makers on an exchange that quotes away from the NBBO. Unless the Proposal is substantially modified, it is difficult to escape the conclusion that the "obligation to seek price improvement" will have little or no impact on Brokers' order routing decisions and price competition will diminish.
4. Decreases the Incentive For Customers To Enter Limit Orders
The Commission has emphasized that "displaying customer limit orders in the quotation can increase price competition,"12 and, further, that the "potential of limit orders to narrow quotes...may encourage the entry of additional market orders."13 Thus, encouraging the entry of price improving limit orders is a highly desirable objective. But under the Proposal and the Linkage Plan the incentive for customers to enter such limit orders will be substantially decreased.
Market makers have little incentive to quote new, better prices when Brokers have no obligation to route orders to the best market and market makers on other exchanges can step up and match the better prices. Why should a market maker take on such risk when doing so will not increase the order flow to its exchange? For precisely the same reason, public customers will have little incentive to enter limit orders that improve published prices. Customers will quickly come to understand that (1) Brokers have no obligation to route orders to their newly established best prices; (2) market makers on other exchanges may trade ahead of their orders simply by matching the limit prices; and (3) if the market moves against their orders, market makers will quickly and easily pick them off through the linkage.
Under these circumstances, a customer entering a price improving limit order appears less likely to get a "better" execution than to be a source of quick profit for a market professional. People adjust their behavior to bring their risks and rewards into balance. Under the Proposal and the Linkage Plan, the risks and rewards available to customers for entering limit orders that improve the published quotation will be out of balance. Customers will adjust their order entry practices accordingly.
5. Fosters Order Routing To The Highest Paying Exchange Without Any Customer Disclosure
The detrimental consequences of the Proposal's elimination of any meaningful best execution responsibility on the part of Brokers will be exacerbated by the options exchanges' "marketing programs" that pay Brokers for order flow. Because Brokers will have no practical constraints on their ability to route customer orders to any exchange they chose, the allocation of order flow among the exchanges is likely to be determined in substantial part by the nature and amounts of the payments Brokers receive. Indeed, under the Proposal, it is difficult to see what incentive or obligation Brokers would have to allocate retail size customer orders based on any other factor.
Not only will payment for order flow be the dominant factor in determining relative market shares, but Brokers will be under no obligation to disclose to their customers their order routing policies or the extent to which those policies are influenced by order flow payments. At present, Brokers are not, and under the Proposal they will not be, required to make any disclosures to their customers concerning whether they accept payment for options order flow, whether such payment affects how they route options orders, or whether and what payment was received in connection with any given customer's option transaction.14
In the equity markets, these disclosures have been required for over five years. Broker-dealers must disclose to each new customer and to all customers annually, the broker's policies regarding the receipt of payment for equity order flow and their policies for determining where to route customer equity orders that are the subject of payment for order flow. (Rule 11Ac1-3) In addition, broker-dealers must indicate on each customer confirmation whether payment for order flow is received for that type of transaction and that detailed information is available concerning the payment received with respect to that particular transaction. (Rule 10b-10(a)(i)(c)) The purpose of these disclosures, according to the Commission, is to "assist customers in assessing the quality of [the] trade executions they receive" as well as to inform customers about their broker's "order handling practices."15
The absence of comparable disclosure with respect to options execution quality is ironic given Chairman Levitt's recent statement that "execution quality matters" and the Proposal's purported objective of providing "customers with important information and facilitat[ing] an individual investor's ability to actively monitor whether his or her order routing firm is fulfilling its best execution obligations,"16 In Wolverine's view, there is no justification for customers in the options markets not being provided by their Brokers with the same disclosures regarding order routing and payment for of order flow practices that are now provided to customers in the equity markets.
6. Continues the Inefficiencies and Illiquidity of the Two-Tiered Market For Options.
The Proposal would subject options quotations to the Firm Quote Rule and require that those quotations be firm to both customers and broker-dealers. The Commission should be commended for this very positive step. But the Commission has proposed, as one of two alternatives, that options quotations could be firm to broker-dealers in an (unspecified) amount less than that for which they would be firm to customers. In proposing this alternative, the Commission stated that unless quotes were firm to broker-dealers to a lesser extent than to customers "options market makers may be inclined to limit exposure to other professionals by widening their spreads or limiting their firm quote size, which would be to the detriment of public customers."17 We do not agree with this view.
Under the Commission's proposed amendments to the Firm Quote Rule, market makers would have no ability to "limit" their firm quote size: the size to which quotes would be firm would in all cases be set by exchange rule and, therefore, would not be susceptible to change by individual market makers. Further, to suggest that market makers would widen their spreads if they were exposed to broker-dealer orders to the same extent as they are to customer orders appears to be inconsistent with the view the Commission expressed earlier this year when it approved the NASD's new Nasdaq National Market Execution System ("NNMS").18 Through NNMS, Nasdaq market makers, other NASD member firms, and public customers all will have "equal [electronic] access to the current inside market in NNM [Nasdaq National Market] securities." In approving this feature of the NNMS, the Commission stated that it "agrees with the NASD that allowing automatic executions for broker-dealers' proprietary trades [against the displayed NBBO of Nasdaq market makers] potentially may encourage broker-dealers to commit capital to the market, thereby adding to the depth and liquidity of the market for NNM securities."
Market makers in NNM securities do not act differently from market makers in options. If allowing broker-dealers to have access on the same terms as public customers to market maker quotes in NNM securities will add to the depth and liquidity of the market for those securities, then allowing broker-dealers and public customers to access market maker quotes in options on the same terms will also add depth and liquidity to the market for options. Accordingly, Wolverine can see no justification for the Commission's proposal to allow the firm quote size on an option exchange to be good to broker-dealers to a lesser extent than it is to public customers. If the Commission is serious about "encourag[ing] the removal of barriers to access, and the use of efficient vehicles to reach, better prices on another market," Wolverine urges it to require that market maker quotes be firm to broker-dealers to the same extent as they are to public customers.
II. ALTERNATIVE APPROACH TO ORDER ROUTING AND BEST EXECUTION
Wolverine has a major stake in the efficient and fair operation of this country's options markets. Therefore, Wolverine offers the following suggestions for modifications in the Proposal in the sincere belief that they will alleviate the problems identified in the preceding sections.
1. Disclosure By Brokers of "Non-Best Market Executions"
In proposing the Trade-Through Disclosure Rule, the Commission stated that the rule is intended "to better inform customers about the implications of their brokers' execution decisions" and "to ensure that [a Broker's] decision not to pursue publicly-displayed superior prices is rooted in the interests of customers, not intermediaries."19 Wolverine fully supports these goals. Unfortunately, the Trade-Through Disclosure Rule, with its exception for orders sent to a linked exchange, would undermine rather than advance these goals. What is needed, instead, is an appropriately designed disclosure requirement that would provide meaningful information to customers, encourage Brokers to route orders to publicly displayed superior prices, and, in Chairman Levitt's phrase, "fuel more competitive pricing."20
Wolverine believes that in the options markets Brokers, as a general rule, should route their customer orders on an order-by-order basis to the best market. This is what customers deserve and should expect; it is not technologically difficult; and it flows directly from Brokers' best execution responsibility. Yet the disclosure obligation in the Proposal encourages Brokers to route orders on a bulk basis to maximize order flow payments. Accordingly, Wolverine recommends that the Commission withdraw the proposed Trade-Through Disclosure Rule and adopt in its place a rule that would encourage Brokers systematically to route customer orders on an order-by-order basis to the exchange with the best prices at the time the orders are routed. This could be easily accomplished by requiring any Broker routing a customer's orders in listed options to disclose to that customer each time an order for his or her account is not routed to the exchange publishing the best price at the time of the routing (1) the fact of that routing and (2) the reason for the routing choice. If multiple exchanges were publishing the best price, a Broker could route an order to any one of those exchanges. Such a "Non-Best Market Disclosure Rule" should, of course, contain exceptions to the definition of "best published price" similar to those in paragraph (b)(4) of the Trade-Through Disclosure Rule, but otherwise would be straightforward.
The adoption of a Non-Best Market Disclosure Rule would have three major benefits. First, it would affirm rather than reduce Brokers' obligation to seek best execution. Second, it would create a real incentive for market makers on competing exchanges to engage in aggressive price competition. And third, it would substantially reduce the power of payments for order flow to affect Brokers' order routing decisions. Wolverine strongly urges the Commission to proceed with the adoption of such a rule.
2. Permit Access By Broker-Dealers To Routing and Execution Systems on the Same Basis As Public Customers
We discussed above the importance of market maker quotes being firm to broker-dealers and public customers to the same extent. In addition, the achievement of a national market system for options depends on broker-dealers having the ability to access routing and execution systems on the same basis as public customers. To realize the Commission's objective of "encourag[ing] the removal of barriers to access, and the use of efficient vehicles to reach, better prices on another market," Wolverine recommends that the Commission act to eliminate three types of inappropriate and unnecessary barriers to broker-dealer access to better prices.
First, permitted broker-dealer access to the intermarket linkage is far too limited. If this linkage is to realize its promise of providing an efficient vehicle to reach better prices on other markets, it should be generally accessible by any market maker in any options class.21
Second, the various exchange automated execution systems (such as RAES on the CBOE and AutoEx on the Amex and the PCX) are not now open to broker-dealers. Once market makers' options quotations are required to be firm to both public customers and broker-dealers on the same terms, Wolverine can see no justification for continuing to limit access to these automated execution systems to public customers. RAES, AutoEx, and other similar systems are efficient vehicles to reach market maker quotations and should be open to public customers and broker-dealers alike.
Third, various exchanges prohibit the direct electronic routing of broker-dealer orders to a DPM or specialist.22 Wolverine is well aware of the importance of assuring priority for customer orders, but customer priority can be assured without imposing anticompetitive barriers to broker-dealer access to market maker quotes. Accordingly, Wolverine urges the Commission to review and force the repeal of all exchange rules that limit electronic access to the quotes of options market makers by broker-dealers or other market makers.
3. Prohibit Exchanges from Requiring Market Makers to Pay for Order Flow
Wolverine strongly opposes payment for order flow under any circumstances. The practice is inconsistent with the promise and objectives of the national market system; it is contrary to a broker's agency responsibilities; it masks the true inside quote; it prevents customers from receiving best execution; and it fosters oligopolistic, anti-competitive business relationships. Despite claims to the contrary,23 Wolverine does not believe the practice can be justified and would welcome the opportunity to discuss with the Commission and its staff the basis for this belief and the evidence available for the harmful effects of order flow payment in the options markets. Nevertheless, so long as the Commission is prepared to permit payment for order flow to continue, Wolverine urges the Commission, at a minimum, to take two steps to mitigate its harmful effects. First, as we argued above, the Commission should subject Brokers in the options markets to the same disclosure requirements as are imposed on broker-dealers in the equity markets. Second, the Commission should prohibit exchanges from using their self-regulatory authority to force market makers to pay for order flow.
There is a major distinction between individual market makers separately choosing to pay for order flow, and an options exchange, by rule, requiring all of its market makers to do so. The first represents a series of individual economic judgments as to how best to compete; the second is a coercive action by a self-regulatory organization that has no justification other than to bring more business to that exchange. Further, by forcing its market makers to pay for order flow, an exchange compromises its own self-regulatory responsibilities with respect to enforcement of rules applicable to order flow providers. Public customers can only lose when exchanges' regulatory independence is weakened. Wolverine, therefore, urges the Commission to bar any exchange from using its self-regulatory authority to require market makers to pay for order flow.
Wolverine appreciates the opportunity to comment on the important issues raised by the Proposal. We believe that the alternative approaches we have suggested for Broker disclosure, access by broker-dealers to market maker quotations, and strengthening of Brokers' best execution responsibility, will substantially advance the development of a national market system for options.
Very truly yours,
Wolverine Trading, L.P.
Wolverine Trading, L.P.
cc: Hon. Arthur Levitt
Hon. Paul R. Carey
Hon. Laura Simone Unger
Hon. Issac C. Hunt
Annette L. Nazareth
|1||Release at 7.|
|2||Release at 5.|
|3||Release at 9.|
|4||Levitt, "Toward Markets Driven by Footsteps," October 12, 2000, at 5 and 6 ("Levitt").|
|5||Release at 6.|
|6||Levitt at 6.|
|7||Release at 23.|
|8||Release at 4.|
|9||Of course, when market makers, such as specialists and DPMs, act as agents with respect to orders in their book, they may have obligations to use the linkage to obtain a better price on another exchange. In such situations, because option specialists and DPMs are not paid for performance of this agency function, they should have access to the linkage without cost to them.|
|10||Release No. 34-34902, Payment For Order Flow, (October 27, 1994) ("Order Flow Release") at 28.|
|11||Release No. 34-37619A, Order Execution Obligations, (September 6, 1996) ("Order Execution Release").|
|12||Order Execution Release at 17.|
|13||Id. at 50.|
|14||See Release No. 34-34903 and Rules 11Ac1-3(a) and 10b-10(a) (2) (i) (c). Certain order routing disclosures would be required of Brokers with respect to options orders if proposed Rule 11Ac1-6 is adopted. See Release No. 34-43084 (July 28, 2000). But even under this proposal, options exchanges, unlike equity markets, would not have to disclose information concerning execution quality. See proposed Rule 11Ac1-5.|
|15||Order Flow Release at 8 and 24.|
|16||Release at 8.|
|17||Release at 6.|
|18||Release No. 34-42344 (Jan. 14, 2000).|
|19||Release at 5.|
|20||Levitt at 2.|
|21||The Linkage Plan, as currently drafted, limits access to the linkage to "eligible market makers" and further limits use of the linkage by these market makers to 20% of their total transaction volume. In approving the Linkage Plan the Commission does not comment on, much less justify, limiting the availability of the linkage to eligible market makers, and it justifies the 20% limitation solely on the ground that it prevents "the linkage from becoming a means of wide scale proprietary trading by broker-dealers on markets in which they are not members." Wolverine recognizes that linkages should not become an alternative to exchange membership. Nevertheless, utilization of the intermarket linkages by broker-dealers generally will contribute to aggressive intermarket price competition. Therefore, Wolverine urges the Commission to amend the Linkage Plan to allow access to the linkage by any market maker on any exchange up to 20% of that market maker's transaction volume and by any market maker that is a member of the exchange receiving the orders to an unlimited extent.|
|22||For example, Amex Rule 950(c) and Amex Notice, August 26. 2000 prohibit competing market makers from transmitting orders to a specialist's post by means of the Amex's electronic order routing and processing system. This rule and others like it are symptomatic of the persuasiveness of the anticompetitive two-tiered market that exists for options.|
|23||See, e.g., Order Flow Release at 6 ("payment for order flow may result in lower execution costs, facilitate technological advances in retail customer order handling practices and facilitate competition among broker-dealers and securities markets.")|