Speech by SEC Commissioner:
Remarks Before the Securities Industry Association
Options Market Structure Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, New York
October 24, 2006
Good morning. I am delighted to have been invited to speak today at the SIA's Options Market Structure Conference. I am especially pleased to be able to speak to you about how the options markets have innovated in the recent past and about further changes that are on the immediate horizon.
Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
Options exchanges have undergone remarkable changes in the last several years and they continue to innovate and improve. Since at least 2000, we have witnessed several fundamental market reforms. These include listing products on multiple exchanges and the entrance of new, fully-electronic markets. An inter-exchange linkage system was established, trade-through rules for options were adopted, and reforms were implemented increasing market maker quote competition. We have seen price improvement mechanisms adopted in some markets as well as improvements in how OPRA secures additional capacity. More recently, new classes of market makers have been able to participate from off the trading floor at several exchanges. And of course, the options markets continue to integrate systems and expand their automation such that the vast majority of orders and quotes are entered and executed electronically. As a result of these and other developments, the quality of the options markets has improved considerably, with narrower spreads and increased liquidity contributing to better trade executions. Indeed, over this period we have witnessed dramatic growth in the options markets. In 2005 and 2004 alone we saw increases of 25.7% and 30.8%, respectively, over the prior year. Clearly, these market developments have been a "win" for everyone.
In introducing structural changes that increase inter-market and intra-market competition, the options markets have followed in the footsteps of the equities markets and, not surprisingly, have achieved similar salutary results. However, the options markets have yet to make the leap to quoting in penny increments. As you know, in 2001, the U.S. stock markets changed from fractional to decimal pricing and introduced smaller trading increments. At that time, the options exchanges prevailed upon Congress and the SEC not to mandate quoting in penny increments because, it was said, they would overwhelm the capabilities of the systems that collect and disseminate options quote and trade data (OPRA), as well as exchange, broker- dealer, and vendor systems.
Initial feedback on penny trading in equities evidenced reduced spreads. This was clearly a boon to investors. Critics, such as institutional investors, claimed the smaller increments made trading more challenging and costly. In their view, smaller tick sizes resulted in smaller displayed sizes at the inside quote and thus, less price transparency. They warned that this could precipitate consolidation of market intermediaries. Liquidity remained, however, although it now appeared at multiple price levels, which required market participants to adjust their trading strategies. Several years have passed since these initiatives were first implemented and liquidity remains robust as does the competition among numerous market intermediaries.
But today, the options markets continue to quote in five and ten-cent increments. I believe this has the effect of maintaining artificially wide spreads. Pricing inefficiencies caused by nickel and dime minimum increments correspond to a proliferation of payment for order flow practices and internalization arrangements. A move to quoting in penny increments in options could substantially reduce payment for order flow. That is, as spreads narrow, the amount that dealers are willing to pay to attract order flow could be reduced. The move to penny increments in equities greatly reduced spreads in those securities resulting in a commensurate decrease in payment for order flow.
But change in quoting increments is, in fact, on the horizon. This past June, SEC Chairman Cox sent a letter to the six options exchanges urging them to undertake quoting in pennies for a limited number of options series beginning in January 2007. In response to Chairman Cox's June letter, the ISE and NYSE Arca proposed a six month penny pilot in 13 options classes. These proposals were published by the Commission earlier this month. Under these exchanges' proposals, all series of the QQQQ would be quoted in pennies and series priced below $3.00 in 12 other equity options classes would be quoted in pennies. Series priced $3.00 and higher in these 12 pilot classes would be quoted in nickels. The exchanges propose to begin the pilot on January 26, 2007.
The 12 pilot classes were selected because they represent a range of trading activity. The exchanges will submit a report at the end of the 4th month of the pilot that analyzes the quality of quotes and the impact on capacity during the first 3 months of the pilot.
We recognize that quoting in pennies will substantially increase message traffic and that the exchanges, vendors, and securities firms must have a plan to mitigate the voluminous quotes that could result from penny quoting. We are also well aware that quote traffic is a major issue particularly at the opening and in volatile markets. And what has been the response of the exchanges and other interested parties, such as vendors and broker-dealers? Well, unlike in 2004, the options exchanges, vendors, and SIAC seem more amenable to finding solutions to the message traffic dilemma. SIAC has indicated that it could double its capacity from its current rate of 125,000 messages per second. The exchanges have proposed solutions to mitigating message traffic. For example, ISE proposes to limit the dissemination of quotations for a prescribed time period of no more than 1 second. Thus, if there is a change in the price of a security underlying an option, the ISE would not disseminate each market maker's individual quote change, but would wait for up to 1 second and then disseminate a new quote.
ISE also already has a fee program that requires market makers to purchase more APIs as the market maker generates more quotes, providing an economic incentive for market makers to limit the number of quotes they disseminate. ISE has also committed to delist options with average daily volume of fewer than 20 contracts.
NYSE Arca proposes to reduce the number of quote messages it sends to OPRA by only submitting quote messages for "active" options series. For options not considered "active," NYSE Arca will accept quotes from members, but will not disseminate the quotes to OPRA or anyone else.
All of these efforts will help address message traffic problems generally and will bring penny quoting in options closer to a reality.
Some in the industry have expressed hesitation with the pilot. They cite the possibility of a lack of liquidity at the top of the book, similar to what occurred in the equity market. Others express concern that without depth of book transparency, trading options in pennies will be more difficult. Some take issue with the particular options classes in the pilot, as well as the length of time that the pilot will be operating.
All of these concerns are matters to be seriously examined. But I believe a pilot will generate an enormous amount of helpful data that we can analyze. The data we collect will inform our next steps with respect to penny pricing of options. Our experience with equity penny pricing showed that while changes did occur when we moved to penny increments, markets adapted to those changes. Our market structure is not static. It will continue to innovate and respond positively to these innovations.
The options markets have also made great progress in the area of price competition generally. Several exchanges now offer special "auctions" through which customers may be able to trade in penny increments at prices better than the quote. These "auctions," however, do not affect the National Best Bid or Offer (NBBO), and so, they do not affect the majority of retail trades. Since the prices available in the auctions cannot be seen or accessed by members of other options exchanges, they can be traded-through as well. Exchanges have recently proposed price improvement mechanisms that do not require a sponsor to guarantee the improvement, and so, would expand the universe of orders that may obtain penny price improvement. While I encourage expanding such price improvement opportunities, I believe these price improvement mechanisms do not substitute for exchanges displaying quotes at these better prices, where such quotes are accessible and subject to trade-through restrictions.
Brokers are continually challenged to make critical yet nuanced decisions when determining where to route their orders to satisfy their best execution obligations. Specifically, the duty of best execution requires broker-dealers to seek the most favorable terms reasonably available under the circumstances for a customer's order. Such determinations involve a variety of considerations. This duty does not require automated routing on an order-by-order basis to the market with the best quoted price. Rather, the duty of best execution requires brokers to periodically assess the quality of competing markets considering a variety of factors to assure that order flow is directed to the markets providing the most beneficial terms overall for their customer orders. This periodic assessment must take into account price improvement opportunities across markets. As I mentioned, competitive market forces have led to trading rules and systems that provide opportunities to trade options at prices better than the displayed NBBO. Brokers therefore must consider that executing customer orders at the best displayed price alone may not satisfy these best execution obligations. Brokers cannot simply ignore opportunities for price improvement when making their best execution determinations with respect to customer options orders. And brokers certainly cannot permit the receipt of payment for order flow or internalization arrangements to interfere with their best execution responsibilities and determinations.
In 2000, following the listing of many options on more than one market, Commission staff found increased competition for options orders, but also found that the introduction of payment for order flow (including exchange-sponsored programs), internalization, and other inducements to firms to route their customer orders to particular markets had an impact on order routing decisions.2 In fact, the staff found that firms that accepted payment for order flow rerouted orders to specialists that paid for order flow more frequently than firms that did not. The staff also found inadequacies in the comparability of data that limited the ability of order routing firms to measure the quality of competing markets. In its report, the staff expressed concern that payment for order flow and internalization in the options markets contributed to an environment in which quote competition is not always rewarded, thereby discouraging the display of aggressively priced quotes, and impeding better prices for investors.
The Commission's recent examinations on options order routing and best execution practices were very heartening. They revealed significant improvements over the last five years in firms' options order routing processes and showed an increased use of "smart router" technology to ensure that marketable retail customer options are directed to the market displaying the best price. Because more than one exchange frequently displays the best price, however, firms continue to rely on competitive factors other than price to determine where to route customer orders. That is, payment for order flow, internalization, reciprocal arrangements, and other inducements appear to have increased since 2000 and continue to play a substantial role in broker-dealers' order routing decisions. Also, it is not clear that brokers are taking full advantage of the price improvement mechanisms offered through some exchanges for a meaningful amount of their order flow.
The Commission has several tools at its disposal to foster greater competition in options quoting, reduce inefficiencies, and improve transparency of the options exchange execution quality. My preferred tool would be to implement execution quality statistics for the options markets similar to those we have for the equity markets. A lack of transparency concerning execution quality impairs the ability (and motivation) of broker-dealers to trade between the quote. Execution quality statistics would provide brokers the information to assess and compare execution quality across exchanges and modify their order routing practices based on current information about exchange performance. Further, such statistics would enable customers to monitor their broker's handling of their orders, should they so desire. I think published uniform information about a market's execution quality would facilitate comparison across the options exchanges and ultimately inform market participants about the results of their routing choices.
Another topic I would like briefly to discuss that has an impact on the options business is the use of portfolio margining. Portfolio margining is undoubtedly a more efficient method for managing risk to broker-dealers when extending credit than the current strategy-based approaches being used. There has been much focus recently on the need to update how margin requirements are determined. As you know, margin levels are important for a host of reasons. They are important from a competitive standpoint in that they determine how much credit can be extended to purchasers of securities. The higher the credit extension, the more products that can be sold. They are also important to our financial system as a whole. By limiting the amount of leverage in the system, margin requirements limit systemic risk.
As a general rule, initial customer margin requirements for securities are established by the Federal Reserve. The Fed has delegated the authority to establish customer maintenance margin requirements to the exchanges, subject to approval by the Commission. The Federal Reserve further delegated authority to the exchanges to establish initial and maintenance margin requirements for options on equity securities, again subject to Commission approval. Very generally, SRO rules require 20 percent of the underlying security as initial and maintenance margin for short options. Margin protects a broker-dealer in the event the option is exercised and the customer fails to deliver the underlying security in the case of a naked, short call option or to purchase them in the case of a naked, short put option. SRO rules currently have lower margin requirements for certain options spreads where options positions are hedged with other options on, or securities positions in, the same underlying security. In this case, the margin is reduced. This margin method, referred to as "strategy-based" margin, is the method currently in use today.
The Federal Reserve also permits all securities to be margined using a portfolio margining methodology pursuant to an approved SRO margin rule. In July of 2005 the SEC approved, on a two-year pilot basis, companion portfolio margining rules of the NYSE and the CBOE. These rules permit certain customer accounts of members of those exchanges to use a portfolio margining methodology on securities and futures positions based on broad-based securities indices, such as the S+P 500 and the NASDAQ 100. In July of 2006 the Commission approved an expansion of the prior portfolio margining pilot to include listed, single stock options and securities futures contracts based on individual securities. The Commission is now considering margin rule amendments filed by the NYSE and the CBOE that would further expand the portfolio margining methodology to include all other equity products, including certain OTC derivatives. Looking further into the future, these proposed SRO rules could be coupled with a program that would permit certain firms to use internal models to set margin requirements for their customers, consistent with how we have permitted the use of portfolio margining by our Consolidated Supervised Entities. Thus, we would likely examine the risk based margin methods of the firms and also focus on how they manage credit, liquidity, and funding risk as well as market risk with respect to proprietary positions.
As you may know, there is currently a difference of approaches between the securities markets and the futures markets with respect to portfolio margining and those differences have made the opportunity for achieving the true benefits of portfolio margining elusive. The expansion of portfolio margining to include securities, securities options, and security futures products as well as the capability for cross margining is long overdue. I am hopeful that progress can be made in this area through serious quantitative and legal analysis conducted with the help of experts from all corners of the financial services arena. I look forward to participating in that very worthwhile effort.
I hope my remarks today have highlighted some big picture trends concerning our options markets and given you some sense of my aspirations for further market reforms. This is a particularly dynamic period in the options markets and I look forward to continuing to work with all of you as we adapt to all of the market developments yet to come.