From: Bruce Mitchell [bruceamitchell@yahoo.com]
Sent: Wednesday, April 07, 2004 12:48 PM
To: rule-comments@sec.gov
Subject: File No. S7-07-04: Competitive Developments in the Options Markets

Ladies and Gentlemen:
 
I am providing comments to the above referenced release for your 
consideration.
 
I am a professional off-floor options trader.  If you have additional 
questions concerning my comments please contact me.
 
General Comments
 
As the release discusses, in general, electronic trading, intermarket 
competition, and added exchanges have dramatically improved the efficiency, 
i.e. narrower spreads, of options markets in recent years.   Nonetheless, in 
my view, payment for order flow, specialist guarantees and internalization 
have not aided that dynamic and do present potential negatives for the 
options markets in the future.  In addition, on a related subject that raises 
similar issues to ones covered by the release (but not specifically 
solicited), I would like to note that index options, (e.g. SPX) which 
represent by far the highest volume of options traded and a significant 
percentage overall have not enjoyed the benefits or increases in efficiency 
that have occurred in the market as a whole.  I believe this is an important 
area of potential improvement and attention for the Commission.
 
Index Options
 
Let me quote from the release:  "Today, virtually all actively traded equity 
options trade on multiple markets, a development that has enhanced 
competition among the options exchanges."'  
This is patently inaccurate.  The highest volume option traded -- the SPX -- 
is traded only on the CBOE.  And, the spreads commonly present in the SPX 
market are huge compared to the average NBBO spreads (i.e. $0.18) referenced 
by the release.  The SPX is almost never below $0.50 and is usually between 
$1.00 and $2.00.   This is a direct result of the lack of competition in the 
product stemming from the fact that it trades exclusively on the CBOE under 
contractual arrangements with S&P.  This area needs to be exposed to the same 
dynamics as the rest of the market for the benefit of the customer.
 
Payment for Order Flow
 
In my view, payment for order flow has three significant problems:  (1) It 
introduces a potential conflict of interest for the broker-dealer and its 
best-execution obligation; (2) it may reduce the long-term liquidity and 
efficiency of options markets by narrowing the profitibility of market making 
to the point that there are fewer market-maker participants long-term; and 
(3) it disconnects the party delivering the value (i.e. the customer and his 
order) from the party receiving value for the order (i.e. the order 
introducing firm).  
 
History suggests that the potential conflict of interest presented will 
almost certainly, at some point, lead to the abuse of the conflict of 
interest at the expense of the customer.  And, it is extremely difficult for 
the customer to be aware of the abuse of that conflict, to prove the abuse 
and to receive appropriate restituition.  So, it would likely be better if 
the potential for abuse were removed.  
 
Markets work best and are most efficient when there is multiple party 
participation and not overmuch concentration in one or few parties' hands.  
While options markets have become much more efficient in recent years to the 
benefit of the customer, dynamics that lead to overmuch concentration could 
ultimately work to the customer's detriment.  The reduction of profit 
potential from market making presented by payment for order flow, on the 
margin, works to further this undesirable dynamic.  It particularly affects 
diverse, smaller scale market makers, who have to live with often inequitable 
rules governing order flow payment revenue allocations. Diverse market makers 
presence in the markets, long-term would be beneficial to the customer.  
 
Payment for order flow demonstrates that the order has value.  The party 
directly responsible for that value is the customer.  Yet, I would bet that 
most customers would be shocked to learn that their broker-dealer is 
receiving a payment for delivering that order to a given exchange.  It seems 
anamolous that the broker receive value for the customer's order.  (Perhaps 
if payment for order flow is allowed to continue, the customer should receive 
the financial credit; this would ameliorate the potential conflict.)  
 
Specialist guaranties.  
 
Briefly, I believe these work to the long term detriment of the efficiency of 
the market.  They enhance the benefits of scale, which, in turn, over time 
lead to potential greater market maker concentration, rather than the 
efficiency which is favored by diverse market participants.  In addition, I 
do not understand why a larger market maker needs an inducement to carry out 
a function that is intrinsically profitable.  If it is not profitable, they 
will not do it.  As a note, perhaps guaranties make sense for specialists in 
issues with light volume as an inducement to provide a market.  In that case, 
a volume threshold for allowing guaranties might be a reasonable requirement.
 
Internalization.
 
This is a conflict of interest if there ever was one.  Despite attempts to 
sanitize the risk through preceding auctions and other structures, in the 
end, history suggests, smart market participants will abuse this potential 
conflict of interest to the customer's detriment.  And, similar to payment 
for order flow, it is very hard to discern and prove and it distances the 
party bringing the value of the order, i.e. the customer, from the party 
receiving the value for the order.  
 
Thank you for considering my comments.
 
 
Very truly yours,
 
 
Bruce Mitchell