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SEC Staff Will Recommend Uniform Execution Quality Disclosure by Options Exchanges

The SEC's Division of Market Regulation plans to recommend rules to require options exchanges to publish standardized information on execution quality and to make the information publicly available so that customers may monitor brokers' execution of their orders, according to Associate Director Elizabeth King. In remarks at an options industry conference, King said the proposed rule would be patterned on existing rule 11Ac1-5 for stocks. The staff recognizes that changes would have to be made to accommodate the trading characteristics of options such as the series of each options class. King's prepared remarks were posted on the SEC's Web site.

King said that the launch of two new options exchanges and various structural and regulatory changes have improved the market quality for options. The consolidation among options market makers has also led to the payment for order flow and internalization which can create a conflict of interest between a broker's best execution obligation to its customers and the broker's own interests, King said.

The SEC has not chosen to ban these practices, King explained, because it would do little to benefit customers without improvements in the price at which options trade. A move to penny pricing increments in options would substantially reduce or eliminate the payment for order flow, she said. Narrower spreads would directly benefit customers, while any benefit from the payment for order flow is indirect at best. King said the staff continues to evaluate whether the benefits of penny quoting would justify the risk of less accurate information being disseminated.

In a market with internalization and payment for order flow practices, King said it is vitally important for brokers to achieve the best execution for their customers' orders. Brokers have an independent duty of best execution beyond their trade-through obligations, she noted. They must periodically assess the quality of competing markets to ensure that the order flow is directed to the markets that provide the most beneficial terms for their customer orders. King said that brokers must examine their order routing practices as the markets and technology change and to modify their practices for seeking best execution if necessary.

Brokers must take into account any price improvement opportunities across markets, King advised. Since options trade in five-cent or 10-cent price increments, there is room for improvement between the quoted prices. King noted that intermarket competition has led to trading rules and systems that provide opportunities to trade options at prices that are better than the displayed price. She cautioned against letting payment for order flow or internalization arrangements interfere with brokers' best execution responsibilities and determinations and urged brokers to consider price improvement opportunities during their regular review processes. Different markets may be more suitable for different types of orders or for particular securities, King said.

Brokers must have the ability to assess and compare execution quality across exchanges, according to King. Brokers also must ensure that customers can monitor brokers' handling of their orders. They now must publish quarterly reports that detail where they route their customers' options orders for execution and any relationships with the exchanges to which they route the orders, such as profit-sharing and payment for order flow arrangements. The staff believes that rule 11Ac1-5 has worked well for stocks, so is considering a proposal to require exchanges to publicly disclose standardized execution quality statistics on their trading of options.  

King noted that the options exchanges have developed execution quality data at the urging of their members for use in making their best execution assessments of the performance of the exchanges. King said this is a great development, but the statistics are not uniform. They use different parameters for determining execution quality and the information is not public. The staff believes that brokers and their customers would benefit from standardized and publicly available execution quality statistics across options exchanges, King advised, and will recommend rules to require the exchanges to publish uniform information that could be compared across markets. By making the information publicly available, customers will be able to more effectively monitor their brokers' execution of their orders, she concluded.