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SEC Completes Study of Payment for Options Order Flow

Intervention is unlikely, but info will help regulators understand price and order competition.
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Judging from a Securities and Exchange Commission staff report released Tuesday, odds are that if a brokerage firm is getting paid by specialist firms to send options orders to it, the brokerage firm isn't passing that compensation along to the retail customer.

The SEC staff reviewed 24 brokerages that handle retail orders. Nineteen accepted payment for their orders, a common practice in equity trading that's made its way into the options market. In fact, the report said from November 1999 to September 2000, options specialists paid $33 million to brokerages. A specialist, or market maker, matches buyers and sellers at the exchanges, and in cases where there isn't a buyer or seller to take the other side of the trade, a specialist will step in and use its own capital to provide liquidity in the option being traded.

But, "Few firms are passing along the benefits of payment for options order flow to their customers in the form of either reduced commissions or rebates," the study said. Of the 19 firms that accept payment, only one "has significantly reduced retail customer commissions for executing listed options orders" and another "maintains a policy to rebate payments received for order flow to customers."

The study, which was first

announced in July, has been highly anticipated because payment for order has become a bigger issue in the options markets. When options contracts began being listed on multiple exchanges last year, competition among market makers for order flow increased sharply. In addition, multiple listing narrowed spreads between bid and offer prices, cutting into market makers' profits. So they looked for ways to make that up. Even exchanges have begun payment-for-order flow programs.

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The study was conducted by staff from the SEC's

Office of Compliance Inspections and Examinations

and the

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. Payment for order flow is the practice of options specialists and market makers paying order routing firms for their orders.

While the report was critical of the effects of payment for order flow and internalization on the options market, it didn't make any specific recommendations. It said the SEC staff anticipates the report will aid the agency "in determining whether regulatory action is needed to strengthen price competition and order interaction in the options markets."

The study also looked at internalization, though the report said that "internalization of retail customer options orders is not yet a prevalent practice in the options industry." Internalization takes on several forms in the options market. One form of internalization is when a brokerage firm's trading desk uses its retail order flow to spot desirable trading opportunities and then sends a contra order. For example, if the retail customer sends a sell order, the trading desk sends a buy order to the exchange floor.

While multiple listing helped investors by tightening spreads, "by some measures these improvements have been muted with the spread of payment for order flow and internalization." The report said the SEC staff plans to "closely monitor execution quality measures in the options markets."

Big Increase

The SEC staff found that the number of retail orders paid for by specialists "has steadily increased." In August, specialists paid brokerage firms for 78% of the retail orders sent to them, up from 4% in December 1999, and 14% in March.

The report said several brokers that previously had policies to not accept payment for their orders began accepting it when the SEC didn't abolish the exchange-facilitated payment plans that began in the summer. The firms said the fact the SEC didn't abrogate those plans "was tantamount to commission approval," so they began to accept payments.

But the report pointed out that "payment for order flow and internalization create conflicts of interest for brokers because of the tension between the firms' interests in maximizing payment for order flow or trading profits generated from internalizing their customers' orders, and the fiduciary obligation to route their customers' orders to the best markets."