Speech by SEC Staff:
Remarks before the 2007 Options Industry Conference
Elizabeth K. King
Associate Director, Division of Market Regulation
U.S. Securities and Exchange Commission
San Antonio, Texas
April 27, 2007
Good morning. It is a pleasure to be able to speak here again this year. This year's placement on the program leaves me in the unenviable position of being the act to follow the exchange leaders. I doubt that I will be as provocative, but hope to hold your interest. Let me remind you that the views I express are my own and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.1
Fortunately, in recent years, it has been easy to find positive things to say about the options markets. The options markets are growing - in trading volume as well as number of markets - and innovation in trading systems and products is exciting to watch. I think that it's fair to say that the consistent innovative character of the options markets is attributable to its creative and capable participants who are fed by the healthy competition present in these markets. This competition is one the Commission has sought to foster.
An interesting development this year is that the options markets no longer just trade options - each options exchange also operates a stock trading facility. Like other market participants, those options exchanges that did not historically trade stock perceived Regulation NMS as an opportunity to participate in more robust intermarket competition. I anticipate that exchanges will also develop strategies to take full advantage of trading platforms that trade both derivatives and their underlying instruments.
New, innovative products are one area that both the options and stock markets have pursued in the past few years. Exchange-traded funds are no longer only the index-tracking derivative securities they once were. Issuers are designing - and exchanges are listing - a growing variety of products that track not only US and foreign stock indexes, but also fixed income securities, commodities, and currencies. Though these products raise unique investor protection issues, and new challenges for surveillance systems, they provide valuable diversification tools for investors. Options markets understandably are eager to offer options on these novel new securities and such options are important hedging instruments.
Product innovations can also be a source of competition, as different - but economically equivalent products provide market participants with choices. The new exchange-traded credit derivative contracts are an example of a new product developed to compete with the massive over-the-counter credit default swap market. The resolution of how these exchange-traded credit derivative contracts are regulated will have important consequences for the protections afforded participants in this market, particularly the application of the insider trading prohibitions.
Competition among the options markets has encouraged a steady stream of new, trading systems. In an effort to attract order flow, these new trading systems are expanding the opportunities for orders to trade at prices better than the quote. Split price executions that provide orders handled on the floor by brokers with prices between the quote have always been available to institutions able to employ a floor broker. For smaller orders, a few exchanges have implemented "mini auctions" that provide opportunities for price improvement in pennies. However, currently, all such systems require a member to guarantee an improved price before the opportunity for further price improvement can be made available. Encouragingly, however, there are several exchange proposals that would provide the opportunity for marketable incoming orders to receive the opportunity for penny price improvement automatically, without a "sponsor" on the other side of the order.
As noted many times, a best execution analysis must take into consideration the availability of these and other systems that provide opportunities for price improvement. Nevertheless, a staff report on order routing and execution practices released by the Commission earlier this year found that most of the broker-dealers examined expressed reservations about sending order to these price improvement auctions. Generally, though, there has been improvement over the past few years in order routing firms' processes for obtaining best execution. In particular, firms increasingly use "smart router" technology, which allow firms to more quickly and efficiently seek out and route to displayed liquidity and prices.
The Commission staff report also noted that firms' order routing decisions continue to be influenced not only by which exchange has the best price (and the largest size), but also by payment for order flow and other inducements. In fact, unlike in the equities markets, such practices seem to have increased, not decreased. Although such inducements do not necessarily lead to inferior executions, firms must not allow these types of arrangements to negatively impact their order routing decisions and the quality of their customers' executions.
The options exchanges have also made efforts to change the Intermarket Linkage Plan to keep pace with the more automated nature of the individual exchanges and the speed with which orders are handled. Members of exchanges that use the Intermarket Linkage can expect significantly faster order turnaround times than a few years ago. Public customer orders sent through linkage are now automatically executed up to the full size of an exchange's quote. And the exchanges are considering whether to eliminate plan requirements that currently limit the frequency with which broker-dealer orders may be sent through the linkage.
The exchanges have also made changes that acknowledge the importance of speed in execution quality. For example, exchanges are now permitted to trade-through a better price on another market if an exchange does not respond to a linkage order within 5 seconds. And, exchanges may execute orders at prices worse than the NBBO if an order to trade at the NBBO is sent simultaneously.
Now, I'll turn to what many view as the biggest development in the options markets in the past year: Penny quoting. When the Commission's Office of Economic Analysis looked at the quotes in the most active options in 2005 and 2006, it found that they were at the minimum quoting increment for a significant portion of the trading day, and multiple exchanges are quoting at the NBBO. This is certainly encouraging, and a sign of healthy intermarket and intramarket competition, but it raises the question as to whether the minimum quoting increment of nickels and dimes is keeping the spreads artificially wide.
This brings us to the exchanges' proposals to reduce the minimum increment to pennies and nickels in 13 pilot classes. This pilot has been fully rolled out for about two months and is providing the exchanges, the Commission, the industry, and others the opportunity to analyze the impact of penny quoting on spreads, transaction costs, payment for order flow, and quote message traffic.
The staff's observations at this point are, of course, preliminary. The exchanges' analyses of their experience during the penny pilot are not due until next month. We are interested to see what the exchanges have come up with, and what the reports will show. Commission staff is also conducting its own analysis of the impact of the pilot on market quality and quote message traffic. It is fair to say, that we have not seen or heard anything unexpected and the reports so far are positive.
Our preliminary analysis shows that spreads have fallen significantly in all thirteen pilot classes. This reduction in spreads is seen in both the active and less active classes in the pilot. I will note, though, that all pilot classes are among the Top 500 most actively-traded options. This preliminary data also raises the question as to whether further improvements to spreads could be realized if higher priced options were also quoted in pennies.
Not surprisingly, we are seeing a significant increase in the average number of daily quote updates, but have not heard of any problems with the ability of the various market participants to handle the increased quote traffic. We will be interested to see whether there is any evidence that the exchanges' mitigation strategies are having an impact. Finally, early numbers show, as expected, a decrease in depth at the inside in the pilot classes.
These early results are consistent with the move to decimals in the stock market, which did not result in an adverse impact on the costs of retail or institutional investor executions. In general, retail investors are able to trade at better prices because of reduced spreads, and institutional investors have adapted their trading strategies to accommodate the decrease in displayed depth without an overall increase in execution costs. Only time will tell if we see similar results in the options markets, but I am encouraged by the preliminary results so far.
One question I've been asked repeatedly is: What next? The pilot is scheduled to end on July 25th. At this point, I see no basis to recommend an end to the pilot and revert to nickels and dimes in those 13 pilot classes. Whether and how to expand, however, is still an open question for the Commission. My goal would be to expand the pilot so that the benefits our preliminary analysis show could be realized in more products without introducing more quotes than market participants can process on a timely basis. To reach a conclusion in this regard, the staff is looking at whether the impact of smaller increments varies depending upon characteristics such as the price and trading volume of the option. Are there series in which the spread has not narrowed materially?
We also will be looking to see the impact of the pilot on the practice of payment for order flow. Here I would like to emphasize that eliminating payment for order flow was not the reason the Commission embarked on the penny pilot. Payment for order flow is merely a symptom that spreads are too wide. I do not expect that penny quoting will eliminate payment for order flow. But, a reduction in payment for order flow will indicate that spreads have narrowed. In this light, I note that all options exchanges have reduced or eliminated their exchange-sponsored payment for order flow programs in classes trading in penny increments. This is consistent with what we saw when stocks started trading in pennies. I see this as a positive development, particularly if the elimination of these programs is a sign that quote competition in these classes has increased to a point where customers are directly, rather than indirectly, receiving better executions.
Finally, I will note that the Commission approved SRO rules to permit customers to compute margin requirements using a portfolio margin methodology. While the implementation of portfolio margining was long-awaited and eagerly anticipated, it is likely to present new challenges to traditional market participants as customers can now use the leverage available through portfolio margining to better compete.
I also believe that it is important to resolve the so-called "one pot-two pot" issue. The SROs' recently approved portfolio margin rules permit securities positions to be offset by positions in related futures held in the portfolio margin account. However, absent a waiver from the CFTC, futures positions held in a portfolio margin account would be subject double segregation requirements -- under the SEC's customer protection rule, as well as the CFTC's segregation rule. Resolving this issue is important to allow futures and securities to offset each other and to realize the full benefits of portfolio margining.