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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the 2001 Options Industry Conference

by Annette L. Nazareth

Director, Division of Market Regulation
U.S. Securities & Exchange Commission

Tucson, Arizona

April 27, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

Good morning. I am delighted to have the opportunity to address the 2001 Options Industry Conference, and I am flattered to have such a wonderful audience considering the number of options you all have to enjoy the many diversions at this beautiful resort. Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.

I would like to begin my remarks by thanking all of you who participate in the option markets for your hard work this past year. It hasn't been an easy year, but it has been a quite productive one. You settled the anti-trust cases with the SEC and the DOJ, and initiated a program for reforming OPRA. You addressed capacity issues and began the process of linking the markets. You have challenged the status quo and have embarked on a path that I believe, in the end, will lead to stronger and more vibrant markets. I know some of these issues have been difficult, and I realize that frequently we sit on opposite sides of the table, but I am convinced that the net results of these efforts will be positive for investors and positive for the options industry. As far as we have come, however, there remains much to do. Today, in addition to marking our success, I want to use this opportunity to highlight a number of areas in which we must still make progress to secure lasting benefits for investors and the markets.

But first, I'd like to note that not all of our efforts have been adversarial. One of the past year's joint successes, for instance, was passage of the Commodity Futures Modernization Act. This legislation is a victory for those of us that believe that competition must be on a level playing field. In lifting the ban on trading single stock and narrow based stock index futures, Congress established a framework designed to minimize regulatory arbitrage. Our challenge at the Commission is to work with the CFTC to implement the CFMA consistent with this purpose. There is no question that the regulators and the exchanges and firms who plan to trade these new products have a lot of work to do before December when we anticipate these products will commence trading.

All of our efforts in working with the options industry over the past year have been undertaken to achieve what I believe is our shared goal of enhanced market integrity in the options market. No one can deny the importance that perception plays in the securities markets – investor confidence in the fundamental fairness of the markets is essential to their participation. For this reason, I believe strongly that improvements to market structure that are beneficial to options investors will benefit the options industry as a whole. Our efforts during the past year, as well as other efforts that are just now beginning to take shape, have been guided by this underlying principle.

Of course, at times, various segments of the options industry may perceive that certain of these initiatives place them at a competitive disadvantage in the short term. There is no question that change in the way your business has historically been conducted can be painful. But the dynamics of the market don't permit us to stand still. Competition domestically and globally is forcing a fundamental reevaluation of how the securities business is conducted.

The competitive environment in the options market was changed dramatically in August 1999 when wide-scale multiple trading expanded. Regardless of the cause of the dramatic increase in multiple trading, one of the effects is becoming increasingly clear – it has accelerated the development of the options market, so that in many ways the options markets are now evidencing some of the characteristics of the equity market where products have for many years been traded in multiple market centers. These changes, in turn, have significantly heightened the need to develop linkages between the markets; to address systems capacity issues; and to improve market transparency.

Market Linkages

I continue to strongly believe that building linkages between markets is the most efficient mechanism for ensuring that investors receive the best price available for a particular option, regardless of the market to which the order was initially routed. In fact, the Commission has been encouraging the options exchanges to develop an intermarket linkage for many years. The need for an intermarket linkage is now critical because of the marked increase in multiple trading that the options market has experienced over the past twenty months.

The Commission approved an intermarket linkage plan in July of last year and all five options exchanges are currently participants. As you may know, the exchanges recently selected a vendor, the Options Clearing Corporation, to build the linkage and we are continuing to encourage the exchanges to expedite the process of modifying their internal systems to ensure that the intermarket linkage will be fully implemented as soon as possible. To fill the immediate need for a link, however, some of the options exchanges are in the process of implementing an interim linkage, which I understand was launched on a small scale on Wednesday. I am hopeful that once the permanent linkage among all of the options markets is fully implemented, it will make it considerably easier to execute customers' options orders at the best price available.

Market Transparency

If asked, I believe I would rank market transparency as the most challenging issue facing the options industry in the quest for enhanced market integrity. Without accurate, timely, and reliable information about transactions taking place in, and quotations displayed by, a particular market, an investor has little, if any, incentive to part with his or her hard-earned money. Generally, transparency in the markets provides investors with the confidence that they will receive sufficient information to make reasonably informed investment decisions.

The need for market transparency in the options market is greater now than ever before due, in part, to the growth of practices such as payment for order flow and internalization. In response to concerns about the conflicts of interest created by these practices, the Commission's Office of Compliance Inspections and Examinations and Office of Economic Analysis issued a report in December on payment for order flow and internalization in the options markets. In the report, our inspections office found that these practices have spread rapidly since the initiation of multiple trading – growing from practically nil in August 1999 to cover approximately 75% of retail options orders by August 2000. Little evidence was found that the payments to brokers had been passed on to retail customers in the form of reduced commissions or direct rebates. Finally, the inspections office found that broker-dealers currently do not have adequate information to reliably compare the quality of executions among specialist firms, and that independent vendors have been unable to develop reliable execution quality reports because exchanges have not provided them with adequate execution data.

Also in the report, the Commission's economics office attempted to analyze the effects on execution quality of multiple trading and the rapid expansion of payment for order flow and internalization. The results of this analysis were seriously limited, however, by the office's inability to obtain basic order data from all of the exchanges. For example, the analysis could not determine whether orders were to buy or to sell, whether they were market or limit orders, or the time at which an order was received by an exchange. Consequently, one of the most significant measures of execution quality – the effective spread actually paid by investors – could not be calculated in the most accurate manner. Nor could speed of execution be measured. The steps that must be taken to address the current unavailability of basic order data from all options exchanges is an issue I will address later in connection with improved public disclosure concerning options market execution quality. Finishing up with the December report, however, the two measures that could be calculated accurately – the quoted spread and the realized spread – raised troubling questions concerning the effect on execution quality of proliferating payment for order flow and internalization arrangements. Both types of spreads had widened after initially narrowing with the commencement of multiple trading. Taken as a whole, the report is a useful alarm bell that further steps must be taken to assure that investors in fact continue to benefit from the increased competition offered by multiple trading. Moreover, it is essential that execution quality information be publicly available so that everyone, not just the Commission staff, will be able to analyze the quality of order executions available at the various exchanges.

Some have suggested that the Commission should act to completely eliminate the practice of payment for order flow in the options market. We have been reluctant to recommend that the Commission prohibit payment for order flow because of the inherent difficulty in eliminating all types of comparable practices, such as internalization. Instead, we believe it is more appropriate to shed light on these practices and allow investors to decide for themselves the extent to which such practices affect their brokers' ability to fulfill their best execution obligations.

Several initiatives either undertaken or being considered by the Commission and the options industry should enhance the transparency of the options market, allowing investors to more easily evaluate the quality of execution achieved by their broker. These include the new Order Routing Disclosure Rule adopted by the Commission last November, improved order execution quality disclosure by exchanges, and increased transparency in the display of customer limit orders.

First, the new Order Routing Disclosure Rule is intended to give investors and other market participants the tools with which to assess a broker-dealer's order routing practices. Under the Rule, broker-dealers that route customer orders in equities and options will be required to prepare and make available to the public quarterly reports that disclose certain information, including the percentage of total customer orders that were market orders, limit orders, and other orders, as well as the identity of the venues to which they routed orders. In addition, the reports also will disclose the nature of the broker-dealer's relationship with those venues, including the existence of any internalization or payment for order flow arrangements. Finally, broker-dealers will be required to disclose, on customer request, where they routed a customer's individual orders for execution.

The new Order Routing Disclosure Rule should greatly enhance the ability of customers to understand their broker's order routing practices, including potential conflicts of interest. Putting better order routing information in the hands of investors, however, is only half the battle. Knowing where your orders are routed is of limited use in the absence of information on the quality of order executions that is available at the various exchanges. Consequently, it is imperative that investors receive reliable disclosures from all options exchanges concerning their execution quality. As you know, the Commission has adopted an Order Execution Quality Disclosure Rule for the equity markets. Under this rule, all market centers that trade national market system securities are required to make available to the public monthly electronic reports that include uniform statistical measures of execution quality. These measures include, for example, the effective spread for market orders – an extremely valuable statistic that benchmarks a market center's order executions against the NBBO as it stood the moment the order was received by the market center. Other important statistics for market orders include the speed of execution and price improvement and price disimprovement, as benchmarked against the time of order receipt. In addition, the Order Execution Quality Disclosure Rule requires market centers to disclose information on the execution of limit orders, including fill rates and speed of execution.

I believe that all of these execution quality statistics could be quite valuable to options investors, especially in light of payment for order flow and internalization. Before getting there, however, it is necessary to remove the hurdles that currently stand in the way of adopting an execution quality disclosure rule for the options markets. Most importantly, execution quality statistics can be calculated accurately only if reliable raw data on orders, including the time of order receipt, is readily available in an electronic format from all exchanges. The efforts the exchanges are making to design and implement the consolidated order audit trail system, or COATS, for electronic orders will meet this need for electronic orders.

Another hurdle to an options execution quality disclosure rule is the absence of a consolidated BBO in the options markets. A consolidated BBO provides all market participants, including investors, with the benefit of an important source of information regarding the state of the market in a particular options series at a given point in time. It is also essential for the calculation of execution quality statistics. As part of the process of reforming OPRA, the exchanges have agreed that one of the functions of OPRA should be to calculate and disseminate a consolidated BBO. At this point, however, agreement has not been reached on the specifics of how a consolidated BBO would be calculated. Although I recognize the difficulties in achieving a consensus on the methodology for calculating a BBO, I am confident that the exchanges, which all internally calculate a BBO today, will be able to agree to a methodology to make this important market information available to all market participants.

Of course if we embark on that course, we will have to settle upon the right methodology to assure that "apple-to-apples" comparisons of execution quality can be made among different options markets. For the equities markets, statistics must be disclosed on a "security-by-security" basis. This approach clearly would be impractical in the options markets, where there may be hundreds of series of options for one underlying security. At the appropriate time, I would welcome any ideas that the industry may have on this issue.

Finally, as the options market continues to evolve, the absence of a market-wide requirement that all customer limit orders be immediately displayed and, therefore, transparent to all options market participants, becomes more problematic. The immediate display of customer limit orders would add another form of competition to the quote, potentially narrowing the spread and lowering costs for investors.

As many of you are undoubtedly aware, under the Commission's rules, in the equity market, absent certain exceptions, all customer limit orders that would improve the bid or offer must be displayed immediately. Although the Commission's Customer Limit Order Display Rule has not been extended to the options market at this time, this may be an issue that will demand the attention of the new Chairman and Commission, once confirmed. Several of the options exchanges currently have filings pending with the staff that would impose similar requirements on their specialists by exchange rule. We will continue to work with the exchanges to bring greater transparency to all customer limit orders that improve the bid or offer.


We have come a long way this past year, and as you can see, our work is still not done. Maintaining market integrity and investor confidence is an on going process that pays big dividends. I believe that we must continue to invest in efforts to increase transparency by linking the various markets, by improving execution quality disclosure, and by displaying all customer limit orders. Our markets are not the strongest, most vibrant in the world due to some happy accident, serendipity if you will. They are so, because of our commitment to protecting investors, a commitment we must maintain. Thank you for your kind attention.


Modified: 04/30/2001