March 14, 2014
Re: Release No. 34-71208 File No. Sr-ISE-2013-72
To Whom It May Concern
The ISE Exchange recent proposal to amend their QCC Rules is ridiculous and self-serving. The proposal will only serve to further degrade the trading of listed options and move closer towards an Over-the-Counter (OTC) style marketplace for OCC backed products.
As an equity derivatives market participant and analyst, I have personally observed firsthand many due diligence abuses and customer harm created as a direct result of the QCC order type over the past few years. The proposal by ISE to now reduce the size of contra parties will exacerbate an already egregious problem
In practice, market participants have utilized the QCC order type to disadvantage customers and avoid due-diligence obligations in TWO primary ways, which I will chronicle in fine detail.
Abuse Method 1: The QCC order type allows brokers, or other market participants, to cross structured orders OUTSIDE of the net NBBO market for the stock/option package. This means orders can be effected which do not have to adhere to best-ex standards on a net cash basis. Although, the QCC requires the OPTIONS leg to print on or inside the NBBO, it does not preclude the broker from printing the STOCK leg at ANY price they want. Therefore, on numerous occasions there are QCC orders that will have the options leg print on the NBBO and then we'll see a corresponding stock print way outside the NBBO. This creates a net LOSS to the customer relative to current published markets.
For example
Suppose a customer gives an order to a broker to buy 1000 SPY Mar 175 Calls and sell stock on a 25 delta (neutral basis) as a market order.
At the time of the order the markets in each product are
SPY Mar 175 Calls: 2.93 bid for 2,300 at 2.95 offer on 1,799
SPY stock 172.25 – 172.26 (25k x 30k)
Whereas, if the broker executed this order immediately on the net NBBO markets (that is on the options AND stock NBBO) the NET credit to the customer would be
1. Buy 1,000 SPY Mar 175 Calls for 2.95 = $295,000 debit
2. Sell 25,000 shares SPY at 172.25 = $4,306,250 credit
3. Net Credit to customer is $4,011,250
However, if the broker instead chooses to shop the order and find a counter-party with which to effect a QCC cross with, the broker may put the trade up at almost any level they so choose. For instance, the broker can utilize the QCC mechanism to put up the trade as such
1. Buy 1,000 SPY Mar 175 Calls for 2.95 = $295,000 debit
2. Sell 25,000 shares SPY at 172.20 = $4,305,000 credit
3. Net credit to customer is $4,010,000
The difference using the QCC cross facilities is a net LOSS to the customer of $1,250
The broker can technically print the stock leg at ANY level they want by tagging it as a derivatives related QCT print. Therefore, by combining the QCC cross facilities with the QCT stock exemptions net losses are created for customers ALL DAY LONG in the options markets.
The defenders of the QCC order types attempt to use several flawed arguments to defend their practices.
The first thing they point out is that because the order types are structured, that is stock/option combination orders, there's NO guarantee the NBBO on both the stock and option market could be captured by executing the order in the open market. To be certain, that is in fact sometimes the case. However, by NOT exposing these order types to the open competitive market, there's also no guarantee that a BETTER price could not have been achieved for the customer than the one they effected the cross at on QCC.
In an open-outcry market, which requires every order be taken into a trading crowd and exposed prior to execution, we find price improvement for these very same order types (stock/option combinations) all day every day. It is by EXPOSURE that we find the best price at which to execute trades.
The ISE themselves, in their proposal states,
"Allowing smaller orders to participate on the other side of QCC Orders not only provides the best price and opportunity for a trade to occur in a tight and liquid market, but ensures that the highest possible number of liquidity providers are able to participate."
To be absolutely CERTAIN, the BEST and most EFFECTIVE way to ensure the highest possible number of liquidity providers are able to participate on a trade is to EXPOSE it to the open market. The QCC order type does NOT require exposure at any juncture.
The ISE makes this argument very weakly. In reality, what they mean is "liquidity providers that the broker chooses to contact."
The other weak argument QCC defenders make is, "There are pits in the open-outcry exchanges which have remote specialists, or no market-makers present, which in effect is the same as a no-exposure QCC trade." Again, this argument fails because at any time on an open-outcry exchange, a market-maker or competing floor-broker can walk over to a remote pit and lay a competitive market.
In practice, this happens every day on the physical exchanges. There are large market-making groups that have people ready at any time to walk into a pit and compete for an order, even if they're not physically stationed there all day. Furthermore, floor brokers can receive competing orders and go into any trading crowd to make a competitive market. Again, with the QCC order type the ability to price-improve an order is completely stripped from the market place because it is NEVER exposed
The ISE then goes on to argue
"Limiting participation only to liquidity providers who are willing to participate on the trade for 1,000 contracts conversely could result in an inferior price by shutting out some participants due to the large size and thereby minimizing the opportunity for competition and price improvement"
What the ISE does not mention is that by its very nature the QCC order type LIMITS participation on an order to counter-parties that have been selectively shown the order by the broker handling it. If the ISE is so concerned about MAXIMIZING the opportunity for price improvement and competition, they should be making the argument for exposure to the ENTIRE marketplace, not just selective counter-parties.
Abuse Method 2: The various Exchanges have created a fee structure for QCC orders that is a noticeable conflict of interest among market participants. This conflict of interest entices executing brokers to utilize QCC facilities to earn a "rebate", which are often times at the detriment of their respective counter-parties.
It must be understood that the QCC order type is executed at a premium rate on the various exchanges. A cursory review of the Exchanges fee structures will show that QCC fees range from $0.00 - $0.10 for parties clearing as customers, and from $0.10 - $0.20 for any party clearing as non-customer. Furthermore, we find that PHLX, AMEX, ARCA, and ISE offer broker rebates for orders that are executed via the QCC mechanisms.
The invitation is basically being made to brokers "Put this trade up on QCC. Not only will your order bypass exposure to that pesky competitive open market, but well REBATE you for doing so." Everybody wins... except the CUSTOMER
This so called "rebate" has created a TREMENDOUS conflict of interest for brokers handling large orders. They are enticed to find the other side of a trade as quickly as possible and slap it up on the QCC to get that rebate. What they don't realize, or maybe even care about, is the QCC cross is generating exorbitant and unnecessary fees for their counter-parties on the trade.
A brokers adherence to due diligence should not only require that they make every effort to obtain the best price on a trade, but also to mitigate unnecessary fees whenever possible. This diligence is eschewed when an enticing rebate is dangled in front of them.
Many savvy counter-parties have recently become aware of the QCC fees being charged to them by the Exchanges, and have gone about addressing them in two different ways. Some participants specifically request brokers to "NOT put my trade up on QCC", thereby not having to worry about being subjected to extra fees. Other counter-parties, knowing the broker will probably put the trade up on QCC, will account for that and make a slightly less competitive price to in effect "cover" the extra exchange fees. Again, this is a net loss to... the customer
In practice, we've seen this firsthand on the exchange floors. Upstairs brokers will call down the portion of a trade with counter-parties that are adverse to QCC executions, to be executed in open outcry. After we execute that portion of the trade on our floor, we'll see a much larger print go up on the ISE QCC mechanism. These are trades where a portion was already executed on the exchange floor, and could have had the entire trade executed in open outcry thereby saving all the respective counter-parties a TON of exchange fees. However, the executing broker instead chooses to put the trade up on ISE QCC and get their "rebate", regardless of how much it costs their counter-parties in fees.
In my opinion as a market participant, practitioner, and observer, the SEC should strike down this most recent proposal by the ISE Exchange. The proposal most certainly will exacerbate an ongoing problem and will further erode market efficiency and price discovery. In addition, the SEC would be well served to further examine the Qualified Contingent Cross and see that is has created extremely detrimental harm to all options market participants.
In its original QCC approval the SEC stated
"qualified contingent trades are of benefit to the market as a whole and a contribution to the efficient functioning of the securities markets and the price discovery process"
The Commission now has several years worth of evidence and data which it can draw upon to find the QCC order is NOT the same as a QCT order. Quite the contrary, the QCC order type has created a shadow market that allows for avoidance of price discovery and a much less efficient market overall. The exact OPPOSITE of what the Commission is trying to accomplish
I'm happy to discuss these findings and any others regarding this order type at any time.
Darren Story, CFA