The Securities And Exchange Commission To Study Effect Of Payment For Order Flow and Internalization In The Options Markets

The Securities and Exchange Commission will conduct a study of the development of payment for order flow and internalization arrangements in the options markets and any changes in market quality since multiple trading. The goal of the study, which will be conducted by the Office of Economic Analysis along with the Office of Compliance, Inspections and Examinations, is to better inform the Commission about the nature, scope, and prevalence of these arrangements and their influence on order routing patterns. In addition, and more fundamentally, the study will attempt to determine the effect of these practices on quote competition, spreads, and execution quality. Because payment for order flow and internalization is a new development in the options market, the data from the previous year may offer a unique opportunity to isolate and examine causal relationships between the practices and changes in execution quality. The Commission intends to make the findings of the study public in November.

Background

Nearly a year has passed since most exchange-listed options began trading on multiple exchanges. This period has been characterized by intense competition for options order flow among options market makers and exchanges. In the first month of multiple trading, spreads in some actively traded options tightened by between 15 and 44 percent, according to an analysis performed by the Commission's Office of Economic Analysis. By the end of October, the spread in more than three quarters of all options that began trading on multiple exchanges since August had declined by 15 percent or more.

More recently, payment for order flow and internalization arrangements have proliferated in the options markets. Some market participants and investors have expressed alarm in response to these developments. Options exchanges also have noted serious reservations, with one exchange calling for a moratorium on payment for order flow in the options markets in January of this year.

Since its growth in the 1980s in the equities markets, the Commission has made clear its concern about the practice of payment for order flow. It has repeatedly recognized that the practice constitutes a potential conflict for brokers handling customer orders, and that it may present a threat to aggressive quote competition. At the same time, we have acknowledged that payment for order flow is not necessarily inconsistent with a broker's duty of best execution, and that it has become a feature of competition among our equity market centers. The Commission decided not to ban payment for order flow in the early 1990s. In considering the arrangements, the Commission noted that payment for order flow is, in substance, the economic equivalent of internalization.

The Commission continues to believe that a ban on payment for order flow is not adequate to address the concerns presented by internalization. Given the diversity of economic models represented by our five options exchanges, the many possible forms of internalization in those markets, and the highly dynamic competition among them at this moment, the Commission is extremely reluctant to take action that would prescribe the form of intermarket competition. While we remain steadfast in our commitment to foster competition among and within options markets, our role is not to pick winners or losers, directly or indirectly.

The Commission remains deeply concerned, however, about practices or arrangements, including payment for order flow and internalization, that may reduce the level of interaction between buyers and sellers in the options markets, or otherwise compromise quote competition. It is critically important that we understand their effects as fully as possible.