April 3, 2000
Mr. Jonathan Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: Release No. 34-42456; File No. 4-429
Proposed Options Market Linkage Plans
Dear Mr. Katz:
OptiMark Technologies, Inc. ("OptiMark")1 appreciates the opportunity to comment on the plans proposed by the options exchanges for the purpose of creating and operating an inter-market linkage for multiply-traded options (the "Options Linkage Plans" or "Plans").2 In October, 1999, the Securities and Exchange Commission (the "Commission") issued an order directing the options exchanges to act jointly to develop such a proposal.3 OptiMark strongly agrees with the Commission that an inter-market linkage will benefit investors and the options markets. OptiMark, however, believes that mechanics of the linkage proposed in each of the Plans do not fully satisfy the Commission's goals and that the Plans should be approved only after changes are made to address best execution of all customer orders across all market centers.
The goal of a linkage is clear: to build a system that, for years to come, will ensure that customers have their orders handled in a manner that they have the right to expect. The Commission has long recognized that an inter-market linkage is essential to increase competition among options exchanges (and market makers) and to ensure best execution of customer orders.4 This need has been heightened by recent increases in multiple listing of the most active options. The Commission ordered the options exchanges to work together on a linkage plan because it concluded that the time had come for substantial progress towards the goal of market integration.
II. The Proposed Linkage Approach -- ITS Plus for Options -- Is Not Adequate
The Options Linkage Plans, however, would improve only marginally on the current, flawed approach to equity market linkage, which is the Intermarket Trading System ("ITS"). ITS has been widely criticized by the securities industry (as well as by Chairman Levitt) as an inefficient, antiquated system that struggles to provide a reasonable linkage between the equity exchanges.5
Like ITS, the linkage proposed in each of the Plans would be used by market makers on one exchange to access superior quotes displayed by market makers on another exchange. Although the proposed system would address a few of ITS's glaring problems,6 these improvements would not outweigh the deficiencies in the linkage's basic structure, as set forth in more detail below.
A. Customer Limit Orders Have Been Overlooked
OptiMark believes that the linkage discussions have placed too much emphasis on which exchange's market makers can trade with a customer market order (or marketable limit order) and, as a result, have overlooked the treatment of customer limit orders. The ability of these limit orders to interact with the flow of incoming orders deserves more attention.
So far, the debate over the Options Linkage Plans has focused primarily on the issue of price/time routing. The options exchanges agree that an inter-market linkage should provide access to superior quotes displayed on another exchange and should prohibit trade throughs. They disagree, however, over whether to require that customer orders be routed between exchanges based on price/time priority. The Plans submitted by the Amex, CBOE and ISE would not include such a requirement. Accordingly, an exchange that is not quoting at the national best bid or offer (the "NBBO") when it receives a customer order (or that was not the first to quote at that price) could match the NBBO and execute the order internally. In contrast, under the Phlx Plan, that order automatically would be routed to the exchange that was the first to display the best price (i.e., "strict" price/time priority). The PCX Plan incorporates a hybrid approach.
Because the NBBO essentially represents professional trading interest,7 this debate boils down to which exchange's market makers should have the first opportunity to execute an incoming customer order. The smaller exchanges support price/time priority; they feel that price-matching puts them at a disadvantage because their market makers get a "first look" at fewer customer orders. The larger exchanges feel that the smaller exchanges are attempting to gain through regulation what they have been unable to accomplish by competition. The smaller exchanges maintain that fair competition should be defined narrowly as price competition. The larger exchanges maintain that fair competition should be based on all factors relevant to attracting order flow, including fees, trading services and technology, and the speed and reliability of execution.8
OptiMark acknowledges that price/time routing is a legitimate approach to addressing market fragmentation.9 OptiMark also understands the options exchanges' concern that a new linkage system might negatively affect their competitive status. However, the focus on quote competition between exchange market makers has distracted attention from another, equally significant issue: best execution of customer limit orders no matter where those orders are held in the national market system. OptiMark believes that the Commission should not approve the Options Linkage Plans until the exchanges do more to ensure that customer limit orders have the opportunity to interact with the flow of orders on the other side of the market.
B. Price/Time Routing May Cause More Problems than It Solves
Moreover, in OptiMark's view, a linkage that includes mandatory price/time routing may cause more problems than it solves, especially as the markets change. Options currently are traded in price increments of 1/16th of a dollar, but, by the time a linkage is implemented, the market probably will have begun trading in nickel increments. That will be followed by a drop to increments of a penny. As a result, even if strict price/time priority were in effect, an exchange could step ahead of another exchange's quote or a customer limit order by improving the NBBO by as little as a penny.
For this and other reasons, decimalization is likely to result in more frequent quote changes. A superior quote displayed on another exchange might no longer be available when a linkage order arrives there. To the extent that the market moves against the customer in the interim, mandatory price/time routing could even be counterproductive.
Finally, the increased volume of quotes for stocks (due to the same forces described above) and the extension of the trading day will force market makers to rely more heavily on computers and derivative pricing models for automatic generation of quotes in their option series. As quotes in an underlying stock change, these models will send waves of quotes in the corresponding options. In such an environment, price/time priority would become a contest to determine whose computer can update its quotes faster and in what sequence. That contest would result in quotes with minimal depth and that might not reflect any perceived value.
III. An Alternative Approach to Linking the Options Markets
In light of the deficiencies in the Options Linkage Plans, OptiMark recommends that the Commission consider an alternative approach. This approach is founded on two principles: First, a linkage should increase the opportunity for best execution of customer limit orders. Second, today's technology can do much more than "ITS Plus" contemplates to further the interests of investors and the options markets.
A. Best Execution of Customer Limit Orders
OptiMark strongly agrees with Chairman Levitt's recent comments regarding the "critical market function" served by limit orders.10 As Chairman Levitt stated, limit orders not only help reveal the supply and demand for a security (thereby allowing all market participants to better determine prices) but they also ensure that public investors are an "important driver" of price competition.11 The ability of market makers to trade ahead of limit orders previously displayed by another exchange may reduce the likelihood of execution of limit orders and thus the incentive for investors to enter them.
Accordingly, OptiMark believes that a linkage with the following structure would do the most to enhance the overall efficiency of the options markets. A customer market order (or marketable limit order) initially sent to a particular exchange should have the opportunity to be executed on that exchange at the NBBO or better. This would promote aggressive competition between market centers based on both price and services (e.g., fees, trading services and technology, speed and reliability of execution) and reward innovation.
If, however, that exchange does not execute the incoming customer order, it should be routed through the linkage to fill customer limit orders displayed by other exchanges. If there are multiple customer orders at the same limit price, whether on one exchange or several, they should be filled based on time of entry. All customer limit orders at the NBBO must be satisfied before a market maker on any exchange could trade with the incoming order at that price.
Under this approach, there would be greater opportunity for natural buyers and sellers represented on different exchanges to meet without the participation of a market maker. In addition, price/time priority does make sense for customer limit orders. Investors who take the risks of being a price-setter (i.e., that the market will move away and the limit order will not be executed) should receive the benefits.
B. The Time Has Come for a Centralized Routing Mechanism
To implement such an alternative, a linkage system would need to include a centralized routing mechanism that could track all customer limit orders by time of entry and direct the appropriate portion of an incoming order to each receiving exchange. While that may not have been feasible decades ago when ITS was created, it certainly can be accomplished with today's technology.
A centralized routing mechanism also could have other advantages, especially to the extent that quotes are displayed with size. If a portion of an incoming linkage order remains unexecuted after satisfaction of customer limit orders, the remainder could be split among the various exchanges' market makers in proportion to their indicated depth commitment. This proportionality feature would provide market makers with an incentive to quote in larger size, which would enhance the depth and liquidity of the options markets. In addition, with this structure, an order could be entered into the linkage on behalf of a customer who does not wish to divulge his or her full trading interest without fear that the customer's identity or the full extent of the customer's order would be disclosed to market participants.
In summary, OptiMark recommends that any linkage approved by the Commission contain the following elements: (1) immediate price improvement or execution at the NBBO for customer orders; (2) priority of customer limit orders over market maker interest at the same price; (3) incentives for market makers to quote larger size, thereby improving depth and liquidity; and (4) a high degree of automation, including anonymity features to facilitate the foregoing.
We hope our comments will be useful to the Commission and its staff. If you have any questions, please do not hesitate to contact me at (415) 383-6910.
OptiMark Options / Derivatives
1 OptiMark is a research and development firm focused on application of computer technology to develop and improve markets and exchanges for all buyers and sellers. OptiMark has developed, among other innovations, a new approach for the processing of trading interest known as "OptiMark Trading SystemTM." A trading system based on OptiMark's technology was developed on behalf of the Pacific Exchange, Inc. ("PCX") and currently is available to PCX members and their customers as an exchange facility. See Securities Exchange Act Release No. 34-39086 (September 17, 1997). A similar application is available for Nasdaq securities. See Securities Exchange Act Release No. 34-41967 (September 30, 1999).
2 The American Stock Exchange LLC ("Amex"), Chicago Board Options Exchange, Inc. ("CBOE"), International Securities Exchange LLC ("ISE"), PCX, and Philadelphia Stock Exchange Inc. ("Phlx") filed their Plans on January 19, 2000. The Plans filed by the Amex, CBOE, and ISE are identical, while the PCX and Phlx each filed a separate Plan.
3 Order Directing Options Exchanges to Submit an Inter-Market Linkage Plan, Securities Exchange Act Release No. 34-42029 (October 19, 1999), 70 S.E.C. Docket 2074.
4 See, e.g., Release No. 34-42029, supra note 3.
5 See, e.g., Responding to Chairman Levitt's Call: A Plan for Achieving a True National Market System (February 29, 2000) ("Industry White Paper") at note 20 and accompanying text. ITS covers only a few thousand issues trading in price increments of 1/16th of a dollar. Its inefficiencies would be compounded in the options markets, where there could be 140,000 or more option series trading in penny increments in the foreseeable future.
6 The improvements over ITS would include (1) automatic execution of certain linkage orders in the receiving exchange's electronic systems (rather than simply delivery of "commitments to trade") and (2), for linkage orders that are not eligible for automatic execution, a fifteen-second window during which the receiving exchange must respond (versus sixty seconds or more of exposure for ITS). See Section 7 of each Plan for further discussion of the types of orders that may be sent through the linkage and the applicable procedures and requirements.
7 Options market makers are not subject to the Commission's limit order display requirement under Rule 11Ac1-4. As a practical matter, the NBBO reflects a market maker's quote, rather than a customer limit order.
8 The picture is complicated by the lack of unanimity among the exchanges' member firms or even between business units of a single member firm. Firms with a retail customer base are primarily concerned with the speed of execution of small orders. On the other hand, firms with an institutional customer base do not want to expose large orders to a market where a ten contract execution buys valuable information regarding supply and demand. Nor do they want to send a series of small orders over an extended period, which is time consuming and creates the risk that the market will move before completion of the trade.
9 For instance, the Industry White Paper, supra note 5, advocates the adoption of an automatic price/time priority rule for equity securities. Similarly, the Commission's concept release on market fragmentation solicits comment on the advisability and practicality of a national linkage system for all displayed trading interest. See Notice of Filing of Proposed Rule Change to Rescind [New York Stock] Exchange Rule 390; Commission Request for Comment on Issues Relating to Market Fragmentation, Securities Exchange Act Release No. 34-42450 (February 23, 2000), 65 FR 10577 (February 28, 2000).
10 See Visible Prices, Accessible Markets, Order Interaction, Remarks of Chairman Arthur Levitt at the Northwestern University School of Law and Kellogg Graduate School of Management, Chicago, Illinois, March 16, 2000.