Speech by SEC Staff:
Remarks before the 2008 Options Industry Conference
Erik R. Sirri
Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
Las Vegas, Nevada
May 2, 2008
Good morning. It is a pleasure to be able to join you here this year. I want to thank the Options Industry Council for inviting me to speak at this important event. Before I begin, 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
In recent years, we have seen a continued evolution of the options markets. Institutional participation in the options markets, including hedge funds and mutual funds, has been growing over time as restrictions in funds' investment policies on the use of derivative products ease and education increases. These new market participants bring new trading strategies and needs to the marketplace. There also have been several key regulatory developments, most notably the trading of certain options in one-cent increments and the expansion of portfolio margining. In addition, current market volatility has been feeding interest in options products.
New markets (seven options exchanges at last count!), new participants, and regulatory changes all require adaptation and innovation in the trading and business models of the exchanges and options market participants. It has been fascinating being a participant in the discussions surrounding this transformation and today I would like to share some of my observations.
I will start with what is probably the most talked about regulatory change in this year and last, the so-called "Penny Pilot." The ability to trade in one-cent increments is not new. Split price executions have always allowed traders that use a floor broker to effectively trade at prices between the minimum increment. More recently, some exchanges have offered opportunities to trade in increments smaller than the five or ten cent quoting increment through "mini auctions." However, the ability to quote — as well as trade — certain options in pennies started in January 2007 with the Penny Pilot.
The Pilot began with the exchanges' proposals to reduce the minimum increment to pennies and nickels in 13 classes. Over the last 15 months, the pilot has been expanded twice to include many of the most actively-traded options, and those options in the pilot account for more than 50% of the total options trading volume.
The impact of penny quoting is manyfold. Generally, spreads in the Pilot series have narrowed across all different price and activity levels. I want to emphasize the benefits of smaller spreads to users of the options markets. To illustrate this point, staff in the Commission's Office of Economic Analysis estimated for the 37 classes that entered the Pilot in 2007 how much customers are saving because of narrowed spreads. For trades of 20 contracts or fewer, in these 37 classes, the staff estimates that customers save on average just under a half million dollars each day. These are real, tangible savings.
In addition, because the spreads narrowed significantly in those options quoted in pennies, the options exchanges have reduced or eliminated their exchange-sponsored payment for order flow programs in those classes. Though the elimination of payment for order flow has not been one of the Commission's direct goals, its reduction is a sign that options are being traded at prices closer to their true value.
Also, as expected, there has been a significant increase in the frequency of quote updates in options quoted in smaller increments. I understand that technology vendors are working on solutions to handle the increased data. The increases in message traffic also require other market participants to make technology investments to meet the new demand. We know that there is a real cost to these changes, but note that technology costs generally are decreasing over time. Although Division staff continues to closely watch this increase, and its impact on market integrity, we have not seen significant problems in market participants' ability to handle the increased quote traffic.
Also noteworthy is the decrease in displayed size at the best quoted price in the pilot classes. This was expected, and is in line with what happened when stocks moved to pennies. Even given this reduction, there appears to be sufficient size to satisfy "retail" sized orders. However, as I'm sure you know, there is much debate about the effect of smaller displayed size at the inside on the ability of market participants to effectively execute large-sized orders. As I will discuss in more detail later, I do not think this question can be analyzed without also looking at how trading behavior has, or will, change as market participants react and adapt to market changes.
The impact of the Pilot on displayed size, as well as non-displayed "depth of book," and the impact of any decreased size on market and execution quality, is an area that needs to be carefully analyzed as the Pilot continues. The Commission has asked the exchanges to provide an analysis of the market impact of reducing the minimum price increment, particularly on the ability of market participants to effectively execute large-sized orders. The staff also welcomes input from other market participants — such as institutions, hedge funds, and sell-side firms. I would not be surprised to see changes in the way market participants seek liquidity. Attempting to access liquidity in a penny wide market in the same manner as in a market with wider spreads is unlikely to work. It may well be that it will result in fundamental changes to the way options trading is carried out before the impact of penny increments on the execution of large orders can be fully assessed. In this regard, the staff would be interested in understanding whether larger orders are being broken up into smaller orders to seek out liquidity across exchanges and the impact this may have on execution quality. Are there services or market structure changes that would aid market participants in more efficiently accessing liquidity below the best bid? All information and input will be evaluated by Commission staff and will inform the Commission's evaluation and consideration of future exchange proposals to extend or expand the Pilot.
Several exchanges also reacted to penny quoting by implementing "maker-taker" fee structures. The "maker-take" fee model is not new — it has been used by stock trading venues for years. But, it is new to the options markets. By charging transaction fees to anyone who "takes" liquidity and paying those who add liquidity, this fee structure represents a shift from the model in which customers have priority and generally are not charged transaction fees.
Proponents of the "maker-taker" fee model argue that it provides further economic incentive for market participants to be price improvers. The exchanges that use this model hope that this increased incentive will translate into the exchange more frequently being at the best price, which in turn could lead to the exchange capturing a larger share of trading volume. They also argue that the cost to customers of having to pay a transaction fee should be outweighed by the savings of getting a better execution price.
In a competitive market, it is not surprising that exchanges are responding to the maker-taker fee models of other exchanges. In particular, because of the higher cost associated with using linkage to execute an order on an exchange with a "maker-taker" fee, exchanges are developing systems to increase the likelihood that members will step up and match the NBBO, rather than send orders to other exchanges. In addition, exchanges are increasingly passing through to members the costs associated with accessing another exchange through linkage. By passing through fees, exchanges encourage market participants to access prices offered by a "maker-taker" exchange directly, rather than indirectly through another exchange using linkage.
I note that among markets that trade stocks, several different pricing structures co-exist, with the maker-taker model being one of them. There is no reason to believe that the options markets also cannot support various pricing schemes. However, I believe that an exchange's displayed prices should reliably represent the true prices that are actually available to investors. The wider the disparity in the level of fees among the different exchanges, the less useful and accurate are the prices displayed by the markets. Further, I believe it would be untenable for a market to set its fees at a level that effectively blocks fair and efficient access to that exchange's displayed prices. This is particularly important in a market structure where broker-dealers have a duty of best execution, and with a trade-through rule that provides for intermarket price protection. The benefits of intermarket price protection could be compromised if exchanges were able to charge substantial fees for accessing their quotes.
In no case are existing "taker" fees greater than the penny increment. Accordingly, I do not believe that locking or crossing an exchange's quote is an appropriate response to "maker-taker" fees, and a pattern or practice of such would be inconsistent with the Linkage Plan. As you know, the issues of locked and crossed markets and fees are ones that the Commission has addressed recently in the stock markets. Commission staff will continue to monitor developments in changes to the fee structures, and corresponding changes in behavior, in the options markets, to gauge the impact and see if further action is warranted.
Changes to the intermarket linkage proposed by some of the exchanges also would mitigate the impact of smaller increments. In particular, CBOE, ISE and NYSE Arca filed a proposed new linkage plan that would, among other things, allow market participants to use Intermarket Sweep Orders, or ISOs. This order type would allow a market participant to sweep down liquidity on one market so long as it simultaneously attempts to take out better priced interest at the top of book on other markets. I believe that development of this order type, combined with an initiative to make depth of book information available, would lessen the impact of the decrease in size available at the top of the book.
Though it is undisputed that finer quoting increments reduce the displayed depth at the top of book, undisplayed liquidity is harder to measure but, nevertheless, is an important source of liquidity. Undisplayed liquidity comes in many forms. The floors of the exchanges are the traditional "dark pool." More recently, fully electronic exchanges have developed order types and systems to mimic this type of liquidity. For example, NYSE Arca, Nasdaq, and ISE rules allow for reserve size functionality. Nasdaq has implemented a "price improving" order type that allows orders to be entered in one-cent increments in options that have five or ten cent quoting increments, and the Commission recently approved a similar order type for CBOE. Similarly, last year the Commission approved BOX's "AAO" order that allows public customers to enter orders priced in pennies to interact in BOX's PIP, which orders, if not executed, will be rounded for display. These electronic "dark pools" of liquidity are beginning to take root in the options markets, much as they did on the stock side. These "dark pools" serve an important role in allowing participants interested in trading in large size to find contra-side trading interest with maximum anonymity.
Is an increase in non-displayed trading interest, whatever its form, a concern? Yes and no. While the Commission has emphasized that transparency is a key component of efficient markets, I also recognize that complete transparency cannot be forced upon market participants. I believe that to try to do so would simply force trading off the public markets entirely. Therefore, while transparency should be encouraged and rewarded, complete transparency should not be mandated.
Although I do not believe that the development of additional ways to provide for non-displayed trading interest in the options market is something that needs to be discouraged, it certainly is something that the Commission staff should, and will, monitor. Of significant importance is access to non-displayed liquidity, wherever it may reside. As non-displayed liquidity becomes increasingly useful to investors, the importance of assuring that this liquidity is available to the public on terms that are not unfairly discriminatory increases as well.
I would like to mention portfolio margining. Last year, the Commission approved SRO rules to expand the ability of broker-dealers to determine customer margin requirements using a portfolio margin methodology. This methodology allows firms to looks at a customer's portfolio as a whole and take into consideration offsetting positions when calculating margin requirements. It is the hope that this methodology will improve liquidity and reduce volatility, and better align margin requirements with actual risk. Taking this step also should help U.S. broker-dealers and exchanges more effectively compete with their foreign counterparts.
I understand and appreciate that firms are making portfolio margining available only to their most sophisticated customers at this time in order to ensure that risk continues to be handled appropriately. This conservative approach is responsible, but I hope to see portfolio margining more widely available in the future, provided your experiences with sophisticated customers support such a direction.
Execution Quality Disclosure
The last issue I will mention briefly is improving the public disclosure of execution quality in the options markets. When, as with listed options, the same financial instruments are traded simultaneously at multiple market centers, the quality of order executions, such as price and speed, can vary significantly across market centers. These differences may be hidden from customers' view, though, in the absence of uniform statistical reports that enable the public to make apples-to-apples comparisons of execution quality across all market centers.
As you know, the Commission has required equity market centers for many years to publish reports on their execution quality. These reports can be very useful to order routers in achieving best execution for their customers. The benefits of the reports, however, extend beyond the interests of individual customers. By making execution quality visible, uniform statistical reports can empower competitive forces that enhance overall market efficiency. For example, market centers with superior execution quality can use the reports to demonstrate their strengths to brokers — particularly brokers that might be routing customer orders to inferior market centers. Brokers, in turn, can pressure market centers with inferior execution quality to improve with the threat of shifting their orders to other market centers. The end result is that inferior market centers are likely either to improve or to exit the business, thereby enhancing the efficiency of trading in general.
I believe that the time has come for the options markets to begin producing public reports on their execution quality. As quoting increments narrow and displayed size at the inside quotes decreases, market centers have greater opportunities to benefit their customers by offering price improvement and liquidity enhancement. Conversely, of course, the risk increases that a market center may fail to match the prices and liquidity available at other market centers. Options customers and order routers need and deserve the transparency tools that will enable them to assess whether there are material differences in execution quality at different market centers and to act accordingly.
The SIFMA Options Committee has worked with the options exchanges for several years to develop recommendations that the exchanges could voluntarily adopt in preparing and publishing uniform statistical reports on execution quality. An important goal of SIFMA in developing its recommendations was to reach agreement with the exchanges on recommendations that could be implemented quickly. I understand that SIFMA has just delivered its final recommendations to the exchanges and that the exchanges could begin making their reports available to the public in the coming months. I strongly encourage the exchanges to take this important step as soon as possible and commend SIFMA for its hard work in bringing the project this far.
To achieve their full potential for benefiting customers and promoting market efficiency, execution quality reports should contain statistics that illuminate the critical issues for effective order routing. In today's options markets, one of the most pressing issues is the opportunity for price improvement, and particularly any potential trade-off between improved prices for the customer and payment to the broker for order flow. To fully illuminate this issue, I believe the reports must include statistical evidence that enables the public to balance the probability of obtaining price improvement with the risk, if any, of ultimately obtaining an execution worse than the quotes at time of order submission. The new exchange reports on execution quality should be evaluated to assess whether they fully achieve this important function. If not, the Commission may need to consider whether to adopt its own rule to supplement the SIFMA recommendations.
The direct beneficiaries of effective execution quality disclosure will be options customers, of course, but ultimately the options markets themselves will prosper as customers are attracted to markets that are demonstrably efficient and fair.
In summary, it is certainly a time of great change for the options markets. That is good; I believe evolving markets are healthy, competitive markets. One of the Commission's most important roles is to monitor and guide that change to assure that it will benefit, not harm, the markets and investors. I welcome your help in carrying out that mission.