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Truth Serum: SEC's Options Crusade Overlooks Investors' Interests

Payment for order flow will squeeze small players out of the business, widening spreads.

Last week, the tough-talking

Securities and Exchange Commission

took the four major

options exchanges to the woodshed, claiming they had colluded for years to limit listing of certain options to the detriment of individual investors.

But next time around, when the world decides that paying brokers to send options orders to a particular exchange has damaged investors, the SEC may have only itself to blame.

Amen to the notion that SEC chieftain Arthur Levitt is the champion of the little guy, but the SEC's tinkering in the options market and unwillingness to address the payment-for-order-flow issue may leave investors in a far worse position than before.

Survival of the Biggest
Payment for order flow has hastened consolidation of the options trading industry and investors may ultimately pay the price.

Here's why: The rising cost of being in the floor trading business eventually will leave a few large firms that, absent competition from smaller market makers, will be free to trade at prices less beneficial to investors.

This will happen, SEC critics say, because the competition spurred by SEC-inspired multiple listing has cut into spreads -- the difference between the

bid and

ask prices -- from which floor traders profit. To win the big market share needed to stay profitable, larger firms started to pay brokers for sending them orders.

In essence, these traders get to pay for the privilege of executing trades for less money. It's no wonder independent traders are already abandoning the floor -- for ditch digging perhaps? -- and smaller firms are selling themselves to larger ones such as

Knight Trading

(NITE)

and

Botta Trading

because they couldn't pay for enough orders to break even.

And while few investors may mourn the loss of silly-jacketed traders who seem to serve mostly as extras for

CNBC

broadcasts, one

American Stock Exchange seat owner, Chris Delzio, recently wrote the SEC, warning that independent traders' demise will have ripple effects. "With them gone, so goes the liquidity they provided," Delzio wrote. "This will result in less competition for orders, not more." Delzio no longer trades options but is active in exchange issues.

Earlier this year, the issue of payments was brought before the SEC, which simply said payments weren't a problem as long as the customer received the best price in the market. (The SEC is studying the wider payment-for-order-flow issue, but its report isn't due out until November.)

An SEC spokesman says the issue of what will happen in the future because of payment for order flow is too speculative for the agency to comment on at this time.

Now that such payment plans are being administered by the five options exchanges (The electronic

International Securities Exchange

announced its plan last week.), specialists and market makers are charged between 40 cents and $1 on each contract traded as tithes to their exchange payment pools.

One options exchange executive estimates that because of the rebates for order flow, as much as $250 million a year may be transferred from market makers and specialists to brokerage firms who send customer orders.

As a result, the independent firms that can stick with the business will have to trade more for their own benefit, and the larger ones will have less competition and incentive to improve customer orders. "That money has to come from somewhere; the place it's going to be made up is in

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widening spreads," the executive says.

Independent traders -- such a crucial part of the trading process -- can either leave the floor to trade their own accounts "upstairs" or get acquired by a larger group. They already are grousing that between their seat leases and their contribution to the payment pool, there's little enthusiasm to take the other side of customer orders.

After a while, some of them predict the market will be left to firms such as

Spear Leeds

,

Susquehanna

, Knight,

Timber Hill

and

Letco

. Not bad guys, but if there's no competition, you can't expect them to act like the

Little Sisters of the Poor.

"The bigger issue of consolidation is that while right now the markets look tight and competitive, there's going to be less and less competition," says Doug Engmann, the head of clearing firm

ABN Amro Sage

. "The spreads are tight right now, but that may not hold in the long run."

Amex seat owner Delzio paints a dramatic picture. "It will be probable that the specialist in

General Motors

options at the Amex will also be the specialist in GM" at the

Chicago Board Options Exchange

,

Pacific Exchange

and

Philadelphia Stock Exchange

, as well, he says in his letter. "This is because the larger firms will get larger because the independent market makers will not be able to pay the shakedown money that payment for order flow requires."

Sometimes it won't even be their choice. On the Pacific Exchange, if a market maker has less than a 5% market share in the trading of a specific option, the listings committee can move to reallocate it to larger firm. Those firms are better equipped to live through the pain of tightened spreads and the contributions to the exchange's payment kitty.

As one options-firm trading head says: "There doesn't seem to be much leadership from the SEC addressing the long-term future of the markets and how it will be affected by payment, consolidation and spreads."

We're depending on our readers for sources, rumors and ideas. Send any to our Truth Serum hotline at

truth@thestreet.com.