From: edmund pawelec [edpaw_options@yahoo.com] Sent: Thursday, April 08, 2004 1:40 PM To: rule-comments@sec.gov Subject: File No. S7-07-04 I have been an independent ROT on the PHLX for more than 8 years, trading both proprietary index products and multiply listed equity option index products, with and without payment for order flow. I currently make markets in the OSX and XAU and have stopped trading NEM because it recently became a payment for order flow stock. I have witnessed first hand many of the changes in the industry that have occurred over the last several years. Most of these changes were implemented or initiated during the reign of Arthur Levitt. The rationale espoused for these changes were to provide customers with tighter and deeper markets. Some of these changes have accomplished this objective; others have provided new avenues for the enrichment of large Wall Street firms without any demonstrable benefit for investors. It is cumbersome to address each question posed in Concept Release No. 34-49175, but I will try to address the main points in a general fashion. Decimalization and Multiple Listing - These changes have been a benefit for customers in the options market and have not adversely affected liquidity providers in the market place. Markets by nature are narrower with decimalization: an 1/8 wide spread is now a $.10 wide, etc. The multi-listing change is the impetus behind the spread being $.10 and not $.15 wide. This combination has been effective in the equity option markets because, from a ROT standpoint, slippage is nominal when hedging an option with its underlying. I define slippage as the equity markets adverse move when presented with the multiple market orders ROTs send to hedge their transaction in the options market. As a liquidity provider, slippage is an important concern when making the initial market. A customer maybe able to discover 500 contracts at a given price on one exchange, sating the market on that exchange, and find 500 at the same price on another exchange because the underlying has not changed enough during the hedging process to move that option's market. As an aside, slippage is reason that multiply listing sector index options is not effective. Because the hedging market orders from ROTs hit as many as 20 stocks in a sector, slippage can be significant. It is therefore in the best interest of the customer for all liquidity to be provided in one locale so that the risks associated with a given order can be priced in and the customer has the best opportunity to complete his/her order at the best price. On another aspect of decimalization, further narrowing of spread increments to pennies from nickels provides no meaningful price improvement for customers, yet will allow large firms to price out smaller firms in the short run. Deeper pockets will be willing to take greater short-term risk if they can force smaller firms out in the long run and eliminate true competition and price discovery. Which brings forth the next issue . . . Internalization - This is not a process that is conducive to competitive markets in any way. Giving large firms the right to shop customer orders before bring them to the market place does not provide a means for price discovery, rather it sets the price to the firms advantage. This process already exists, legal or not, and is demonstrated several times a week. It is not uncommon to for me to see the OSX or XAU (two indices that I make markets in) to move $.50 to $.75 before a large order arrives in the market place. This size move in the underlying will move nearly all the options on the board. A floor broker will then enter the crowd with a customer ord er and cross it with the representing firm at a price that was on or near the market before the move in the underlying. I have reported the actions when they occur to market surveillance, but the investigations are lengthy and difficult to follow up on. Enhanced Splits for Specialists - I do not necessarily disagree with this practice since specialists do incur greater operational costs and can provide the largest contra side for a given order. However, the current guidelines for this practice are more than sufficient to provide the specialist with incentive to continue to provide their service. Any larger split, however, would detract from the independent ROTs incentive to improve to improve markets or increase depth. Payment for Order Flow - This is without a doubt the most egregious practice in the options industry. This is simply a means to provide specialists and brokerage house with legal kickbacks. Question 2 of this release asks, "If commenters believe that payment for order flow diminishes a specialist's or market maker's incentive to quote aggressively, why have spreads narrowed over the past few years while payment for order flow increased?" Spreads have narrowed because of decimalization and multiple listing. Narrower increments and increased competition have done the job. The SEC's own studies have shown that markets were not improved as a result of this practice. With all exchanges guaranteeing the NBBO, where is the incentive to improve a market when I have to pay to get the order? If I am not providing the best market then I will not get the order. If I am providing the best market the order will come to me naturally via the representing broker or via linkage or at a minimum another exchange will match my market; either way the customer will get the best price. Realistically, these transactional savings are not passed to the customer. Since the heyday of day trading at the market's peak, commissions and service charges for customer brokerage have remained unchanged or increased while payment for order flow has increased. This practice simply lines the pocke ts of specialists, to whom the payment is made and at whose discretion it is released. Also, these payments are made (at least at the PHLX) on all customer orders regardless of whether that firm accepts payment or not. I am truly at a loss as to how this practice expedites executions, competition, and/or market transparency. I appreciate that I have been given the opportunity to comment on these developments in the options markets. I look forward to the amendment of the errors of the above rules and welcome any changes that enhance the industry. Sincerely, Edmund S. Pawelec, Jr. Sixth Sense Securities, LP General Partner ----------------------------------------------------------------------------- Do you Yahoo!? Yahoo! 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