Speech by SEC Staff:
Remarks before The 2002 Options Industry Conference
by Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities & Exchange Commission
2002 Options Industry Conference
May 3, 2002
Good morning. I am delighted to once again have the opportunity to address the Options Industry Conference. I find this conference a particularly useful vehicle to hear from all of you about recent developments in the options markets - the successes and, more recently, the enormous challenges that you all face in your businesses. It also gives me an opportunity to reflect on what we at the Commission have done for you - or some of you might say, to you - over the past year and what lies ahead for the future. I am sure we all feel at times like we are navigating uncharted waters, many of which occasionally have perilous rapids. And while it would be wonderful to have a map or a guide who is familiar with the terrain, no such aid exists in the fast evolving world of the options markets. From my unique vantage point as a regulator, I would postulate that if one theme has emerged in the last year, that theme would be self-interest motivated by self-preservation. That may sound like a rather pessimistic view, but I don't mean for that to be the case. I believe that at the end of the day we will reach consensus on what is in the best interests of investors. As always, before I begin my comments, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff. 1
I would like to begin by thanking each of you for your efforts over the past year. There can be no doubt that the challenges we faced this past year were enormously difficult and complex. The staff of the Commission is keenly aware of the remarkable pressures that have been brought to bear on the options markets - multiple listing, new market entrants, and decreased volumes have resulted in tremendous competitive pricing pressures and vigorous searches by markets for new and more efficient ways to increase or merely preserve market share. We also appreciate the burdens of balancing the need to survive in a fiercely competitive environment versus the duty as national marketplaces and self-regulatory organizations to assure that our markets are fair and orderly and our investors well protected. Even with these challenges, I continue to believe that the major distinction between the U.S. securities markets and other global markets is the level of investor confidence that can be found in the U.S. Our securities markets are a national treasure because of the priority we place on investor protection, market integrity, and price competition.
Even with this almost unprecedented competitive environment, 2001 will also be remembered as a year of extraordinary cooperation by our industry participants. After the tragic events of September 11, this industry distinguished itself in its showing of compassion and patriotism, by coming to the immediate assistance of its comrades in their time of need. These same markets that compete head to head each and every day for market share - the Phlx and the CBOE on the options side of the business and the NYSE for equities - opened their doors - and indeed their floors - to assure business continuity for the Amex after it suffered damage as a result of the attack on the World Trade Center. It was a remarkable display of nationalism - and I am pleased to report that the recovery from these events has been swift and decisive. These markets are no longer linked arm in arm singing Kumbaya, but rather, are going at each other with the same competitive juices that flowed pre-September 11.
Last year, I spoke of the dramatic changes occurring in the options industry subsequent to the wide-scale expansion of multiple listing that we have seen in the last few years. Multiple listing has, among other things, heightened the need for linkages between the markets, increased demand on systems capacity, raised concerns about the potential impact of market fragmentation, and created new challenges for broker-dealers in their efforts to obtain the best execution of their customers' orders. I'm certain that each and every one of you has personally experienced the effects of wide-scale multiple listing.
One of the implications of multiple listing is the increased potential that a customer's order sent to one exchange may be executed at a price inferior to that displayed on another exchange - the so-called "trade through" problem. I am encouraged by the continued progress that the options exchanges have made in implementing the Linkage Plan. Recent amendments proposed by the exchanges to the Linkage Plan incorporate a specific timetable for testing and full implementation of their intermarket linkage. The proposed implementation schedule calls for intermarket testing to begin on December 1st, with an operational linkage to be in place by April 30th of next year. I continue to be hopeful that once 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.
We must, however, acknowledge one of the more challenging consequences of the wide-scale expansion of multiple listing: it has increased competitive pressures on the options markets. That increased competition, coupled with declining trading volumes across all markets and the threat of new market entrants, has resulted in even more pressure on exchanges and their market makers to attract order flow. Clearly, each of you recognizes that business as usual is not sufficient in today's marketplace - you have no choice but to respond to competitive threats.
Each of the options exchanges appears to be responding by reevaluating its business model and operations, searching for the concept or product that will provide its market with a tangible advantage over its competitors. Such self-examination is, I believe, a perfectly appropriate response.
Payment for Order Flow, Internalization, and Specialist Guarantees
That said, some of the more visible results of such self-evaluation, specifically, certain proposals put forth by the exchanges to enhance their ability to attract order flow, raise significant concerns for the Commission. For example, payment for order flow has become a common practice in the options market. While payment for order flow creates a conflict of interest between a broker and its customer and potentially raises concerns regarding the basis upon which broker-dealers are routing their customers' orders, the Commission has not prohibited this practice. Prohibiting all reciprocal arrangements, of which payment for order flow is only one, would be difficult, if not impossible. Given the continued prevalence of payment for order flow, as well as similar practices, such as internalization, it bears repeating here that broker-dealers must be continuously diligent to ensure that their routing decisions are based solely on the best interests of their customers.
Allow me to spend a moment to explain the staff's current views on internalization. Permitting a firm to internalize its customers' orders is merely a less overt way than payment for order flow to attract order flow to an exchange on a basis other than competitive pricing. Exchanges invariably claim that they need to permit their members to internalize an ever-growing proportion of their order flow to compete with other exchanges. While I understand the competitive pressures, my concern is that exchange proposals - which are efforts to compete for order flow with other exchanges - could potentially reduce competition based on prices. Moreover, these proposals are unlikely to provide an exchange with anything more than a very brief, temporary competitive advantage over other exchanges. It is almost a certainty that each exchange would mimic the proposal of any exchange to internalize order flow, thereby eliminating any advantage. But, the impact on price competition would be lasting and permanent. I view specialist guarantees in much the same way. Specialist guarantees serve to reward specialists for the act of continuously quoting, yet fail to consider, or provide incentives to encourage, the competitiveness of such quotes. As specialist guarantees grow, the incentive for other market participants to improve the quote diminishes. And any advantage a higher specialist guarantee might provide to one exchange would be lost as soon as the other exchanges adopted the same rules.
The fundamental question we must ask, and indeed do ask, when confronted with proposals to enhance members' ability to internalize their customers' order or to increase specialist guarantees is whether such a proposal would undermine price competition to the detriment of investors. We will continue to view skeptically any options market proposal that undermines the ability of market makers to compete on the basis of price.
Similarly, options market makers face competitive pressures from customers with increasingly faster and better technology. In response, we have seen an influx of proposed rule changes in which the options exchanges propose to limit the access by these customers to the exchanges' systems, or to enable exchange specialists and market makers to more readily "break" trades. I fully appreciate that, given the innumerable options series traded, market makers on the floors of the exchanges are subject to significant market risk and are increasingly vulnerable to "electronic arbitrage." Nonetheless, we cannot approve these attempts to "level the playing field" by unfairly discriminating against certain classes of customers and imposing undue burdens on competition. Instead, we will continue to promote a level-playing field by consistently applying standards that promote both intermarket and intramarket competition. Indeed, it is fair to say we have advocated a level playing field in which the markets themselves have newer and better technology that keeps pace with their ever-innovative customer base.
Market Transparency
Market transparency continues to be one of the most challenging issues facing the options industry. As you all well know, without accurate, timely, and reliable information about transactions on, and quotations displayed by, a particular market, an investor has little, if any, incentive to part with his or her hard-earned money. Therefore, I must say that I continue to believe that, given the potential for market fragmentation in a multiple listing environment, the importance of market transparency is as great as ever.
Last year, I discussed several other initiatives either undertaken or being considered by the Commission and the industry to enhance the transparency of the options market. One such initiative I mentioned was the Order Routing Disclosure Rule, approved by the Commission in November 2000, which requires broker-dealers that route customer orders in equities and options to prepare and make available to the public quarterly reports that disclose certain information, including the identity of the markets to which they routed orders and the nature of the broker-dealer's relationship with those markets, such as the existence of any internalization or payment for order flow arrangements. I am encouraged that the information provided under this rule appears to be achieving its goal of permitting investors to better evaluate their broker's order routing practices, including potential conflicts of interests.
Last year, I also spoke of my fervent belief that the options market should have a consolidated best bid and offer. With the advent of multiple listings, it is essential that investors have a convenient tool that informs them of the market that is offering the best price for any options series at any moment in time. I am very encouraged by the options exchanges' recent efforts, through OPRA, to propose and prepare to implement a consolidated BBO. In addition, I believe that a consolidated BBO has the potential to alleviate, to some extent, the capacity problems that have plagued the options industry for the last several years by potentially reducing the amount of quote message traffic that market data vendors must provide to their customers. I remain hopeful that the markets' progress in this area will ultimately enhance the usefulness of options market data for all market participants, including investors.
CFMA
Finally, let me briefly touch on the topic of security futures. We continue to make progress on completing with the CFTC the rulemaking that is necessary to permit these products to trade. One impact that we expect this product to have on the securities markets generally is a greater convergence of securities and futures regulation. This is particularly true in the area of customer margin, where current rules applicable to securities differ markedly from the portfolio margining permitted for customers trading futures. As I'm sure you are aware, we published CBOE's proposal to permit on a pilot basis the use of portfolio and cross margining for certain customers' accounts carrying exchange-listed, broad-based index options, index futures and options on such futures, as well as index warrants and related exchange-traded funds. I am also very encouraged by the efforts of the New York Stock Exchange's 431 Committee to develop proposed changes to the NYSE's margin rules that parallel the CBOE's proposal. These proposals are an important first step towards more widespread portfolio margining of securities products and we are working diligently with the exchanges and the 431 Committee to facilitate their implementation.
Conclusion
Looking back over the past several years, I am pleased by our mutual efforts in guiding the evolution of the options markets. The choices we have made were often difficult and complex and frequently had an impact on the very nature of the marketplace. Fortunately, our guiding principals today are consistent with the principals articulated in 1934 - maintaining market integrity, protecting investors, and enhancing investor confidence. This past year we successfully navigated many turbulent waters, however, there is still plenty of rough sea ahead and it will take our combined efforts to assure that the U.S. options markets maintain their global leadership position.
Thank you for your kind attention.
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| 1 | 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. |
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