Wolverine Trading, LLC
February 27, 2003
Mr. Jonathan G. Katz
RE: File No. SR-BSE-2002-15
Dear Mr. Katz:
Wolverine Trading, LLC is a registered broker-dealer and a member of all United States options exchanges. We have a presence on all physical and electronic exchanges, trading as both Market Makers and Specialists. In addition, we are the only firm that participates as a CMM in all ten bins on ISE. Our core business is proprietary trading and as such, we have a strong interest in ensuring the fair and efficient operation of the securities and options markets. We welcome the opportunity to comment on the proposals in Release No. 34-47186, issued by the Securities and Exchange Commission (the "Commission") on January 14, 2003.
We applaud the Boston Stock Exchange's creation of BOX, an open, fully electronic options trading facility with few barriers to entry and low execution costs. However, we believe the proposed BOX Rules create a significant conflict of interest between an Order Flow Provider's profitability and its fiduciary responsibility to provide Best Execution for the customer. Best Execution derives from the common law agency duties of loyalty and care, obligating an agent to act exclusively in the customer's best interest. Therefore, an Order Flow Provider ("OFP") acting as agent on behalf of its customer in a transaction, is under duty to exercise reasonable loyalty and care to obtain the most advantageous terms for its customer. Our explanation, set forth in this letter, will make it clear that the BOX rules, as currently proposed, provide an incentive for an OFP to put their own interests ahead of providing a customer with best execution.
The duties of best execution have long captured the attention and concern of the Commission. In his presentation to the SIA on November 4, 1999, Arthur Levitt stated: "With more market centers than ever before, the duty of best execution must be woven more fully into the fabric of our markets. It must be at the very core of our promise of integrity to investors - a promise that brokers will act in their customers' best interest when they route and execute orders. It must reinforce competition, rewarding those markets that improve their execution quality, and punishing those that don't." In addition, as stated in his recent letter to the option exchanges addressing payment for order flow and internalization, former SEC Chairman Pitt stated, "I am concerned that the economic inducements to order-flow providers and internalization by member firms create serious conflicts of interest that can compromise a broker's fiduciary obligation to achieve best execution of its customers' orders." As we will discuss, the BOX internalization mechanism, termed the Price Improvement Period ("PIP"), and its built-in matching provisions, encourage order-flow providers to consider their own economic interests over those of their customers'.
PIP Encourages OFP to Violate Fiduciary Duties.
BOX defines an OFP as a market participant that serves as an Agent in representing customer orders. However, many OFPs assume a dual role. By taking the other side of their customers' trades, OFPs act as both Principal and Agent on the same order. This dual role creates a potential conflict of interest for the OFP. As Principal, the OFP is trying to profit by maximizing the difference between the theoretical value of the option and the price that it pays to the customer (the lower the price the OFP pays, the more it will profit). Simultaneously, acting as Agent, the OFP is obligated to obtain the highest price for its customer (the higher the price the customer receives, the more the customer will benefit, and in turn, the more it will cost the OFP acting as Principal). Under the current proposed rule filing by BOX, the Price Improvement Period provides the OFP an economic incentive to violate its Agency responsibility in favor of acting in its best interest as Principal. It also reduces the rights of other market participants, facilitating the OFP's opportunity to profit at the customers' expense.
The proposed rules of PIP encourage the OFP to breach its fiduciary duties, as OFPs will have no incentive to show its best price up front. The rules state that an OFP is guaranteed 40% of the trade whether or not it was the first participant to show the best price. For example, when an OFP brings an order to BOX, it sets the price where it would like to internalize the order. The OFP's initial price is required to improve the NBBO by a minimum increment of a penny. If the order trades at that price, the OFP, by setting the first price, is guaranteed 40% of the trade. If another Market Maker improves the OFP's initial price, the OFP can match the Market Maker and is still entitled to 40% of the order. The OFP assumes no risk for not showing its best price first, and therefore has no incentive to do so.
In its most simple form, if an OFP uses PIP to match a price set by another participant, it is tacitly admitting to violating its fiduciary duty as an Agent for its customer. The OFP's primary obligation is to get the best price for the customer. If the OFP matches a better price, it implies that the OFP was willing to profit at the customer's expense. This demonstrates that the initial price the OFP set for the customer at the start of the PIP was not its best price. If the OFP is inclined to allow the order to trade at the price that it originally set, yet is readily willing to match a competitor's price during the three-second window, clearly the OFP was not seeking the best price for its customer at the beginning of the three-second window. By not acting in the customer's best interest, the OFP has, without question, violated its fiduciary duty to the customer.
Solution - Remove OFP's Participation Rights for Matching
After setting the initial price of PIP, the OFP should not receive participation rights for matching a better price. PIP should become true price, time priority. Removing the participation rights for matching will have many desired benefits:
1) It will increase price competition between the OFP and the Market Makers. The participants who improve the price the most during PIP should get the trade. All participants now have the incentive to produce the best price. This translates into the customer receiving the best price.
2) It will force the OFP to act in the best interests of the customer. The only way an OFP can guarantee its participation rights is to set its initial price at a level that is the most competitive. The initial price produced will benefit the customer at the expense of the OFP trying to internalize. This implies that the OFP is now seeking the best available price for the customer. Thus, the OFP is forced to act in the best interests of the customer and therefore is not violating its fiduciary duty. The OFP and the marketplace have now successfully dealt with the conflict of acting as both Principal and Agent.
Wolverine has always been a strong opponent of an internalization mechanism that does not protect the customers' best interests. Internalization mechanisms as they currently exist, reduce price integrity, erode liquidity and undermine investor confidence. In her SIA Keynote Address on May 24, 2000, Annette Nazareth, Director, SEC Division of Market Regulation states, "If a substantial portion of the total order flow in a security is subject to dealer price-matching arrangements, it reduces the ability of other dealers to compete successfully for order flow on the basis of their displayed quotations... this creates disincentives for vigorous price competition, which, if extensive, could lead generally to wider bid-asked spreads, less depth, and higher transactions costs."
The matching component causes PIP to counteract the customers' best interests. Our solution of eliminating PIP's matching component encourages the OFP to seek the best price for its customer, rather than for itself. Our proposed PIP rule will allow market forces to shape the way an OFP manages the conflict of Principal and Agent, thus reducing the need for regulatory scrutiny and restrictions. In addition, liquidity providers will be forced to vigorously compete producing true best execution. The end result will be increased investor confidence in the marketplace.
We would urge the Commission not to approve the proposal in its current form. To paraphrase former Chairman Pitt, "As a self-regulatory organization, exchanges are obligated to enforce compliance by its members with the securities laws, including its members' best execution obligations." Currently, none of the options exchanges provide an internalization mechanism which properly addresses the inherent conflicts of interest that an OFP has when acting as Principal and Agent. We believe our proposal allows the OFP to truly perform Best Execution practices for its customer and promotes true competition for all market participants.
In addition, it has never been truly clear how the current level of 40% participation for OFPs was derived and/or justified. The OFP is able to see all terms and conditions of the order before the order is exposed to other market participants. This gives the OFP an unfair advantage. This coupled with the inherent conflict of interest associated with internalization raises the question of why an OFP is allowed to participate in its customer order at all, much less at 40%. In light of the growing concerns regarding internalization, market integrity and public investor confidence, Wolverine believes that this is a timely opportunity for the Commission to re-evaluate this "participation" level.
Wolverine appreciates the opportunity to comment on the Proposed Rule Change for the Boston Options Exchange Facility ("BOX"). If you have any questions or need further clarification, please do not hesitate to contact the undersigned.
cc: Chairman William H. Donaldson