Securities and Exchange Commission
By Electronic Mail: email@example.com
Subject: File No. S7-17-00
Firm Quote and Trade-Through Disclosure Rules for Options
Release No. 34-43085; File No. S7-17-00
Comments of Lek Securities Corporation
Lek Securities Corporation ("LSC") strongly supports the Commission’s proposal to amend Rule 11Ac1-7 to require options exchanges and options market makers to publish firm quotes and to require broker-dealers to disclose to customers whenever an order for listed options was executed at a price that is inferior to a better published quote.
Who we are:
Lek Securities Corporation ("LSC") is a broker dealer and a member firm of the New York Stock Exchange ("NYSE"), the American Stock Exchange ("AMEX"), the Chicago Stock Exchange ("CHX"), the Philadelphia Stock Exchange ("PHLX"), the Boston Stock Exchange and the National Association of Securities Dealers ("NASD"). LSC has been in business since 1989, starting as a partnership of options market-makers on the AMEX. In 1993, LSC developed an electronic trading system - currently know as the ROX® system - to provide fast, electronic access to the NYSE's Super Dot system. ROX has expanded to a multi-featured order management system with connections to the order routing systems of all of the securities exchanges in the United States as well as many ECNs and OTC market makers. LSC currently handles approximately 50,000 orders per day.
Many of LSC's customers are professional traders, including regional specialists, who wish to hedge their positions on the NYSE. LSC also has a number of options market makers and specialists as customers, who hedge their options positions in the underlying stock. As a natural extension of its electronic order routing business in the stock markets, LSC has recently began to route options orders through the ROX system to the respective order routing systems of the four options exchanges.
Because of LSC’s extensive experience in the options market making business, as well as its experience in routing orders to options exchanges, we hope that the Commission will find our comments useful.
The Proposed Rules:
LSC believes that trade-throughs will be virtually eliminated if a broker dealer is required to disclose to a customer (except where the customer has specifically decided to forego the opportunity to achieve a better price in order to attain a different objective, such as certainty of execution of a large order) that an order was executed at a price that was inferior to the best published quote. In this respect, LSC also supports the Commission’s proposal not to place an absolute prohibition on trade-throughs.
LSC also supports the Commission’s proposed rule amendment to require options exchanges and market makers to publish firm quotes. In our prior comments concerning the options exchanges’ linkage plans (Release No. 34-43086, File No. 4-429), we already noted that true linkage cannot occur so long as market makers are permitted to refuse to honor displayed quotes. In the absence of a firm quote rule, market makers in one exchange cannot be expected to match a better price on a different exchange, and thus improve the execution price for customer orders, because there is no guarantee that the market maker will be able to cover his position by trading with the exchange that posted the quote.
LSC submits that there are additional important reasons to support firm quotes besides improving customer access to better quotes in away exchanges. First, firm quotes increase customer confidence in our markets; quotes that are not firm smack of manipulation and deception – the "bait and switch" of the options world. Investors in equity securities have become accustomed in being able to trade at displayed bids and offers, and this has created confidence and liquidity in our markets. Second, LSC submits that there exists no good justification for a market maker to display a quote which is not firm. The absence of any good reason to permit a market maker to walk away from his "advertised" price is another reason to require a firm quote rule.
The Commission has proposed two possible alternative formulations of the firm quote rule. The first (Alternative ‘A’) requires quotes to be firm to all market participants for the entire quoted amount. The second (Alternative ‘B’) permits the quote to be firm only for a fraction of the quoted amount where the order that attempts to trade with a displayed quote is for the account of a broker dealer. LSC opposes Alternative ‘B’ because it would permit a two-tiered market - one consisting of displayed quotes for non-professionals only, and only up to a relatively small amount, and the other a "shadow" market for professionals - that would be inconsistent with Congresses objective of a National Market System. Moreover, off-floor professionals play an important role in keeping prices fair for the public. By restricting access by other broker dealers to displayed quotes, this role is muted, and customers do not get the price benefits that are caused by open and free competition.
The following example will illustrate how important it is to allow off-floor professionals to participate in the competitive process. This participation is particularly important in the case of options, which, by their very nature, have a fair value based on an underlying security:
Assume XYZ corporation. It is a large industrial company, with a long history of stable earnings growth. Its stock price has been steadily (but slowly) rising and now trades at $84/share. The public generally treats XYZ as a conservative "buy and hold" investment. Assume now that the fair value of the March 85 calls in XYZ, based on models used by options market makers and specialists is approximately $2.00. As a result, based on a certain projected volatility, a purchaser of these calls would be expected to break-even if he paid $2.00 for the calls assuming that there is no knowledge of future stock price movements. A reasonable market for these calls would be $1 7/8 bid -- $2 1/8 offer. The spread would allow a market maker to buy the calls slightly below fair value and to sell them a bit above fair value.
Given our firm's experience in the options markets, we would expect that investors would want to buy XYZ stock and sell the March 85 calls. The strategy is often referred to as a "buy-write, because the investor buys the stock and subsequently sells (writes) the calls. If the stock rises to $85, for example, the investor would earn $1 on the stock (the difference between $85 and the current price of $84) plus $1 7/8, i.e. the premium received for selling the calls. If the stock price declined, the investor could simply pocket the premium.
If the trend of the public order flow is indeed as we would expect, i.e. that investors typically are inclined to sell the March 85 calls in XYZ, then a market maker or specialist would have an incentive to lower the price of the calls to a level below fair value. Thus one might expect the actual market to be $1 1/8 bid -- $1 3/8 offer, in other words, much lower than the fair market value of around $2.00. (Note that the spread has not widened, but that the level of the quote is lower.) Accordingly, the investor in our example would receive only $1 1/8 if he sold the March 85 call, instead of $1 7/8 which is closer the fair value.
With a firm quote rule, market forces can protect the investor from receiving too low a price as in this scenario. If a price for calls is artificially lowered, and the price must be honored throughout the market, a market professional, noting that the calls had been marked down, could enter a significant buy order and turn a profit. [In the above scenario, such a purchase would realize a profit 5/8 of a dollar - the difference between fair value ($2.00) and current offer ($1 3/8)]. The threat of this happening would prevent market makers or specialists from artificially lowering their quotes from $1 7/8 -- $2 1/8 to be $1 1/8 bid -- $1 3/8 offer, because the specialist or market maker would not want to himself forgo the 5/8 profit opportunity to the off-floor professional.
This competetive market force is muted or eliminated where an exchange can refuse to honor displayed bids, which is permitted, at least to a limited extent, under Alternative 'B'. Non-professional investors generally have no idea of what the fair value of an option is, and only in a truly competitive environment can they rely upon market forces to keep the published value fair.
Alternative ‘A’, much more than Alternative ‘B’, emboldens investor confidence in fair pricing because under Alternative ‘A’, if the price of a security is too low, then another professional will be ready and able to bring the price in line by entering buy orders. Likewise, if the price of a security is too high, then professionals will be ready and able to bring the price in line by entering sell orders. Under Alternative ‘B’, the professionals might be willing to enter the necessary corrective buy orders, but they will not necessarily be able to, because the market maker could refuse to honor the deflated quote. Thus, we submit that allowing market makers to post quotes that are not fully accessible by other professionals undermines confidence in the fairness of our markets.
Another objection to Alternative ‘B’ is that there is no reason to exempt options market makers from the Quote Rule when dealing with other broker dealers. No such exemption exists for traders and market makers in equity securities, and there is better justification for such an exemption in the equity context because equities are generally more volatile. Prices of options are less volatile than equity securities and are therefore less risky to trade than the underlying equities. Only in the case of deep in-the-money calls or puts are options equally risky.
The only purported justification for exempting option markets from the Quote Rule is the supposition that market makers might be inclined to widen their spreads if their quotes were exposed to other professionals. However, we submit that this supposition is unjustified and unsupported by empirical data, and that, in any case, the public is more harmed by non-competitive un-real quotes (as in the above-scenario) than by wider spreads.
For each of the foregoing reasons, Lek Securities Corporation strongly supports the Commission’s proposal to amend Rule 11Ac1-7, as described in Alternative ‘A’, to require options exchanges and options market makers to publish firm quotes and to require broker-dealers to disclose to customers whenever an order for listed options was executed at a price that is inferior to a better published quote. This proposal will improve market transparency and competition, eliminate a potential source of market manipulation, and lower costs for consumers.
Dated: September 19th, 2000
Samuel F. Lek
Chief Executive Officer
Lek Securities Corporation
140 Broadway - 29th Floor
New York, NY 10006