Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.,
Washington, D.C. 20549-0609
Release No. 34-42456, File No. 4-429
Comment on Proposed Options Market Linkage Plan by the American Stock Exchange, Chicago Board Options Exchange, Pacific Exchange, and the Philadelphia Stock Exchange.
Lek Securities Corporation
The Securities and Exchange Commission ("SEC" or "Commission") has requested public comment on the proposed options linkage plans of the American Stock Exchange ("AMEX"), Chicago Board Options Exchange ("CBOE"), Pacific Exchange ("PCX"), and the Philadelphia Stock Exchange ("PHLX") (collectively, the "Plans"). We strongly support inter-market linkage of options exchanges, but we oppose the Plans as unnecessarily complex. Linkage is available now under existing technology, if only the exchanges would remove parochial procedures and rules (written and unwritten) that prevent it.
II. Who We Are.
Lek Securities Corporation ("LSC") is a broker dealer and a member firm of the New York Stock Exchange ("NYSE"), the American Stock Exchange ("AMEX"), the Chicago Stock Exchange ("CHX"), the Philadelphia Stock Exchange ("PHLX"), the Boston Stock Exchange and the National Association of Securities Dealers ("NASD"). LSC has been in business since 1989, starting as a partnership of options market-makers on the AMEX. In 1993, LSC developed an electronic trading system - currently know as the ROXTM system - to provide fast, electronic access to the NYSE's Super Dot system. ROX has expanded to a multi-featured order management system with connections to the order routing systems of all of the US securities exchanges and many ECNs and OTC market makers. LSC currently handles approximately 50,000 orders per day.
Many of LSC's customers are professional traders, including regional specialists, who wish to hedge their positions on the NYSE. LSC also has a number of options market makers and specialists as customers, who hedge their options positions in the underlying stock. As a natural extension of its electronic order routing business in the stock markets, LSC has recently began to route options orders through the ROX system to the respective order routing systems of the four options exchanges.
Our comments are based on extensive experience in the options markets and our long-term operation of an electronic order routing business. We believe and hope that the Commission will find our comments to be helpful.
LSC strongly supports the efforts of the Commission to establish an inter-market linkage plan for multiply listed options. We agree with the Commission that the "options markets have developed sufficiently to make integration not only possible but also critical to promoting vigorous competition among the options exchanges." Accordingly, we believe that the Commission's efforts will be of great value to the investing public.
LSC strongly opposes the Plans, however, as ineffective and largely unnecessary. Indeed, LSC submits that the proposing exchanges know that the Plans are structurally flawed, and propose them in this form to permit delay in achieving true inter-market linkage. The Plans unnecessarily shift the focus of discussion away from what can be done immediately to implement the Commission's goals of increased competition and communication between market centers.
All of the Plans envision a new computer system to connect and route orders between the exchanges as a prerequisite to achieving linkage. Although LSC does not, in principle, oppose a new national order routing system to link the exchanges, such a system would take years to build and would likely be managed ineffectively given the competing interests involved.1. Most importantly, a new national system is simply not necessary to achieve the desired inter-market linkage. Current technology will allow for the Commission's goal to be accomplished now, without substantial changes. Enforcement of current rules, and elimination of artificial barriers to linkage, will accomplish many of the Commission's goals immediately using the exchanges' existing retail order routing systems. The Commission's objectives are too important to put-off until a new national system can be designed and built.
IV. Artificial Barriers to Linkage: Non-Compliance with the Firm Quote Rule.
As a prerequisite to any linkage plan, market makers and specialists must comply with the SEC Regulation 240.11Ac1-1(c)(2), the "Firm Quote Rule". This rule provides, subject to certain exceptions, that "each responsible broker or dealer shall be obligated to execute any order to buy or sell a subject security, other than an odd-lot order, presented to it by another broker or dealer at a price at least as favorable to such buyer or seller as the responsible broker's or dealer's published bid or published offer" (emphasis added). LSC sees no reason why this rule would not apply to the options exchanges. Any attempt at linkage would, of course, be fruitless if a market maker or a specialist could back-away from a published quote when a market maker or a specialist from other exchanges attempts to trade against a published bid or offer. At present, non-compliance with the Firm Quote Rule is almost universal, and supported (officially or unofficially) by the exchanges. For example, the CBOE's Rule 8.51, which properly seeks to protect customers by requiring execution as quoted by the trading crowd, improperly and unnecessarily limits the rule's scope to non-broker dealers. In interpreting this rule, the CBOE has gone even further and specifically concluded that broker dealers are not entitled to receive an execution at the published bid or offer2. Thus, the CBOE has essentially permitted its members to refuse to honor quotes where the buyer or seller is a broker-dealer from another exchange. We submit that such a practice violates the spirit and letter of the Commission's Firm Quote Rule. Other options exchanges have similar rules or policies.
There are other rules and procedures that, purposefully or not, prevent orders from other broker dealers from reaching a trading crowd. For example, CBOE rules do not allow orders from broker dealer to be placed on its electronic book, nor does it allow such orders to be executed by its REAS automatic execution system3. Accordingly, for a broker dealer order to be represented on the CBOE, a two-dollar broker would have to physically run out to the trading crowd. The resulting cost and time-delay effectively prevents broker dealers from trading with CBOE market makers at their displayed quotes. LSC submits that such anti-competitive rules and procedures should be limited or eliminated immediately. To the extent that the rules and procedures have some basis in customer protection, they can and should be narrowly tailored to achieve that goal without unnecessarily inhibiting inter-market competition.
The exchanges' failure to comply with the Firm Quote Rule and other Commission rules and goals permits the exchanges to refuse to trade with broker dealers at their posted quotes, resulting in a two-tiered market. One tier consists of retail customers. The other tier consists of professional traders, but is unpublished. LSC believes that such fractionalization of the market harms the investing public because consumers rely of competition between professionals to produce fair bids and offers. Generally, investors have no ideal of what a "fair" price for an option is. However, investors assume (wrongly under the current system) that if a price were not fair, it would quickly be brought in line by competition among professionals. Where, as now, market makers and specialists can avoid trading with professionals at their published quotes, there is no guarantee that the public will receive a fair price.
LSC respectfully submits that the options exchanges are not exempt from the Firm Quote Rule, and that the Commission could produce considerably more effective inter-market activity immediately by simply enforcing compliance with Regulation 240.11Ac1-1(c)(2) and by prohibiting exchanges from adopting or enforcing any rule, policy, or procedure that has the effect of preventing any order, including an order of a broker dealer, from reaching the usual place of execution or from being executed by the most efficient means available.
V. The Existing Order Routing and Execution Systems are Adequate.
All of the options exchanges already have sophisticated order routing systems in place that they diligently maintain to attract customer order flow. The CBOE has it ORS system; the AMEX the AMOS system, the PCX the POETS system, and the PHLX has the AUTOM system. The exchanges have natural competitive reasons to develop and improve these systems, in contrast to a national linkage system, which arises only by governmental mandate. These systems could immediately accomplish the linkage that the Commission desires - if the Commission directs the exchanges to stop implementing and enforcing rules or policies that close them to broker dealers from rival exchanges.
Example: Assume that the March 30 Calls in XYZ Corp are quoted 2 1/4 bid on the AMEX and that the offer is at 2 1/2. The same option is quoted 2 1/4 -2 3/8 on the CBOE. Now assume that the AMEX receives an order to buy 10 calls at the market. The customer should be filled at 2 3/8, i.e. at the national best offer. However, the AMEX specialist does not care to sell the options at 2 3/8 for his own account. Accordingly, he will try to purchase them on the CBOE. The AMEX specialist could use LSC's ROX system (or a system of one of LSC's competitors) to route his order to the CBOE's ORS system for immediate execution, but CBOE policy prevents him from doing so. Instead, the AMEX specialist must call a floor broker's booth clerk, who then relays the order to a floor broker. The floor broker must then walk the order out to the trading post and indicate the AMEX specialist's willingness to buy the options at 2 3/8. By the time the floor broker arrives at the CBOE post, the 2 3/8 offer might have traded, or the offer may not be honored by the CBOE trading crowd. Current CBOE rules require that the floor broker announce that he is representing a broker dealer and for this reason alone permit the trading crowd to refuse to honor a published bid or offer. Thus the AMEX specialist might not be able to actually purchase options at 2 3/8 on the CBOE, the clearly displayed offer notwithstanding. As a result, the AMEX customer's market order might be filled at 2 1/2, i.e. higher than the national best offer, or alternatively, the AMEX specialist would have to sell below where he is willing to sell based on an offer on the CBOE which the AMEX specialist is unable to take.
LSC opposes the Plans because they defer implementation of the SEC's linkage objective until a new system can be built, when much of the Commission's objective could be obtained by removing artificial barriers to the existing routing systems4. In fact, LSC believes that the existing systems will likely remain superior to the envisioned national linkage system. An interesting analogy exits in the equity market: LSC executes anywhere between 5-10 million shares per day through the NYSE's Super Dot system on behalf of regional specialists. These specialists have access to the ITS system, but they nevertheless prefer to use LSC to access Super Dot because it is technically superior to ITS. A regional specialist is more likely to receive an execution through Super Dot than he is through ITS.5
Another benefit of LSC's proposal to use the exchanges' existing order routing systems to provide linkage is that in order to gain access to a remote exchange, a specialist or market maker from the originating exchange would be required to use a member of the accessed exchange as a broker. Thus a member from the exchange being accessed would be able to charge a commission to the specialist or market maker sending the order. This commission charge would likely be low due to competition amongst floor brokers, but it would eliminate a sometimes expressed concern that the Commission's wish to create linkage would allow "unlimited free access to other exchanges" and thus constitute undue interference in the competitive dealing amongst the four exchanges.
LSC proposes that the Commission take immediate action to remove the artificial barriers that the options exchanges have created to prevent orders from competing market makers from reaching their respective order routing systems. After this has been accomplished, the Commission could determine if sufficient linkage and competition has been attained and then decide whether a mandate to establish an ITS like system for the options market is warranted.
VI. The Plans Do Not Provide Access for all Broker Dealers and Contain Complicated Restrictions.
LSC also opposes the Plans because they do not specifically provide access to published quotes by broker dealers who are not members of competing exchanges. LSC believes that upstairs broker dealers, trading for proprietary accounts, contribute significantly to making markets more liquid and efficient. Thus, the public interest is served best by a linkage system that is available and accessible to all broker dealers.
The Plans also contain unnecessarily complicated rules and restrictions to access. The proposed rules limit who will have access to the system and under what circumstances. Such restrictions are unnecessary and designed to limit the efficient functioning of inter-market dealings. It is noted that similar limitations on inter-market dealings do not exist in the equity markets and they are uncalled for in the options markets. LSC favors unlimited and unrestricted access by anyone to publicly displayed bids and offers. LSC therefore rejects the AMEX/CBOE proposed "80/20 Test" and the PCX proposal to prohibit the transmission of principal orders, except to unlock or uncross markets or to satisfy trade-through liability. Any proposed restriction as to who may trade with a publicly displayed bid or offer would perpetuate the current two-tiered market system, and should therefore be rejected by the Commission.
VII. The Significance of Time Priority Has Been Overstated.
LSC feels that too much of the discussion surrounding options linkage is focussed of whether there should be time priority, or if a specialist of market maker on an exchange with an inferior posted price should be allowed to step-up and match the price of the exchange that posted the better price first. To a certain degree, this discussion runs parallel to the discussion of whether a Central Limit Order Book ("CLOB") should be mandated in the stock market. LSC is of the opinion that the SEC would be well advised to defer the decision on time priority until the issues surrounding a possible CLOB have been resolved and more experience is available from the stock market. Although LSC favors a CLOB and time priority for options, we believe that a step-by-step approach would better serve the interests of the investing public and that much can be learned as the markets further develop. LSC therefore feels that discussion and determination of time priority should be deferred until the Commission has gained some experience with true inter-market linkage.
Competition is a natural economic phenomenon; it is not created pursuant to a plan. Competition is beneficial to the public, but it is also harmful to competitors, particularly those who presently enjoy provincial home-court restrictions on economic rivalry. The Commission would, therefore, be well advised to look carefully and critically at plans designed by such provincial competitors allegedly to increase competition.
The Commission has received wide and broad-based support in its determination that there is a need for more open communication between the options exchanges, and that linkage will lead to more efficient price discovery and competition between market participants. It is LSC's opinion that the current state of affairs, where competition and communication are inadequate, requires scrutiny and that existing impediments must be removed as a first step in accomplishing the Commission's objectives.
As outlined above, the proposed Plans divert energy and attention from what can be done to achieve workable inter-market trading NOW, using existing technology. Competition between markets has already created technologies that will allow smooth inter-market linkage, provided that the exchanges are forced to jettison parochial rules and procedures that restrict broker-dealers from rival markets from obtaining the best quotes and execution. The Commission already has rules in place that, if enforced, would prevent such anticompetitive conduct and permit inter-market linkage. LSC respectfully submits that the Commission should focus on existing rules and technologies, and that, if it does so, it can achieve its objectives without any significant delay.
Dated: April 28, 2000
1 Such administration would be even more ineffective if certain decisions were required to be made unanimously by all of the exchanges as has been proposed.
2 See attached CBOE Regulatory Circular RG98-145 dated December 29, 1998 (Exhibit A hereto).
3 See CBOE Rules 7.4(a), 6.8(a)(i), 23.7 and 24.15.
4 The CBOE does not have a rule preventing broker dealers from using their ORS system for proprietary accounts, but the exchange does not allow such orders to be placed on the electronic book, nor do BD orders qualify for routing to REAS (the CBOE's automated order execution system). However, the CBOE has pressured member firms from accepting any broker dealer orders electronically, and thus created an artificial barrier to linkage. See, e.g., March 28, 2000 Letter Philip R. Schatz to Karen Calvin, Director, Market Regulation, Chicago Board Options Exchange -(Exhibit B hereto) (This letter remains unanswered as of this date).
5 See March 23, 2000 Market Structure Report of the NYSE Special Committee on Market Structure, Governance and Ownership, page 41, fn. 98 (citing SEC's concerns regarding ITS).