Practice options trading volume statistics

The Commission has sought to facilitate the development of competing transparent, connected markets in an effort to protect investors and ensure that they enjoy the benefits of markets driven to innovate, particularly in periods of intense and dynamic competition. The quoted spread is simply the difference between the quoted, or displayed, bid and ask. See Appendix A for a list of the 53 options classes. There are additional recent or planned changes that may have a significant impact on the options markets. Most order routing firms have accepted payments regardless of the uncertainty surrounding the process. Some of the firms characterized liquidity as market share, while other firms characterized liquidity as depth of market or the size of the orders that market centers could efficiently execute. Over the last year, specialists, using their own money or money collected through the assessment of a transaction fee by the options exchanges, began paying order routing firms to send their customer options orders to the exchange post where the specialist trades the options class.

Firm X does receive payment for order flow from the market center through which the transaction was executed. If a specialist decides not to distribute any funds, the CBOE plans to refund the money to those specialists and market makers who paid the fee at that post. The Phlx, PCX, CBOE, and Amex have stated that specialists are expected to use the proceeds of the transaction fee to attract orders in the classes traded at the exchange post where the money was collected. Aggregate amounts of payments to order routing firms vary according to a number of factors, including the length of time the firm has accepted payment for order flow, the number and type of arrangements the firm has in place, and the volume of customer options orders handled by the firm. Conversely, order routing firms with policies to accept payment for order flow contended to Staff that their market quality evaluations often demonstrated that market centers that paid for order flow were the highest quality markets. Merrill Lynch and Co. These firms utilize a variety of systems to route customer orders. No rule explicitly requires listed options to trade only on the floor of a national securities exchange.

Realized spreads are a measure of the realized revenue for liquidity providers in executing a trade after allowing for the informational impact of the trade. All 24 firms reviewed by the Staff stated that they employ internal processes to regularly evaluate the quality of options market centers. Although narrowing over time, the difference continued to exist in June 2000. Since 1973, United States exchanges have listed and traded standardized options on equity securities. Until recently, however, execution quality information for listed equity options was not readily available. Accordingly, the amounts that specialists pay per contract to order flow providers pursuant to the PCX and CBOE plans vary greatly both within and between posts. The Staff found that all firms maintained a policy to regularly conduct market quality reviews.

Knight Financial Products enters into fee per contract arrangements with several firms for July 2000 order flow. The Commission, however, may summarily abrogate such a rule change within 60 days of filing if it appears to the Commission that such action is necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act. From February 2000 to July 2000, at least 11 additional specialist firms entered into payment for order flow arrangements with order routing firms. Because of the entry of the ISE into intermarket competition during the period, however, it is difficult to attribute changes in quoted spreads conclusively to any particular factor. American Stock Exchange, LLC et al. Order routing firms that handle retail customer options orders can be classified into three general groups: introducing firms, consolidators, and full service firms. The Commission did not extend the execution quality disclosure obligation to the options exchanges principally because a standardized NBBO is not, at this time, calculated and disseminated for options trading. The exchanges also have adopted rules to facilitate crossing, or internalizing, larger sized customer orders.

However, Nasdaq members are subject to rules that require them to use reasonable diligence to execute their incoming customer orders at the best price possible under prevailing market conditions. While some firms that accepted payment for order flow acknowledged that such payments influenced their order routing decisions, most firms denied that it had any influence on their order routing decisions. Initially, pursuant to options allocation rules, most individual options classes were listed on only one exchange, giving market participants no choice of routing destinations for their options orders. August 1999 to October 2000. The consolidated BBO indicates how the best prices available to investors are changing during the sample period because many customer trades, particularly automatically executed trades, are executed against the consolidated BBO. Commission approval of the practice, and therefore began accepting payment for order flow. Using the trade execution information provided by Amex, TAG generates a monthly report using a number of different measures of execution quality, including the percentage of executions within the spread, the percentage of trades executed at prices better than the best bid or offer as calculated by TAG, the percentage of contracts traded in excess of 20 contracts at the best quote, the liquidity premium, 58 and the speed of execution. Other specialist firms have taken less analytical approaches to providing information regarding execution quality. The Staff expects that this report will be helpful to the Commission in determining whether regulatory action is needed to strengthen price competition and order interaction in the options markets.

At the same time, other changes in the market could result in increased competition in the markets both on the basis of published quotes, and on broader market quality factors. See Securities Exchange Act Release Nos. The Staff intends to closely monitor the order routing patterns of the firms that accept payment for order flow. November 2000, the Phlx had not yet delivered its daily or monthly quality of execution report to its order routing firms and specialists. While the Commission explored applying the market center disclosure requirement to the options markets, it noted the potentially difficult issues that would need to be addressed before the uniform statistical measures of execution quality that will be available for equity securities can be made available for options. Internalization occurs when the order routing firm routes its customer orders to its affiliated specialist on the various options exchanges and therefore benefits from any trading profits generated by its specialist. As shown in the chart below, effective spreads declined from August 1999 to November 1999 and have remained at approximately their November levels since.

Accordingly, exchanges and their members are competing intensely for those orders. TAG defines the liquidity premium as the dollar amount of variation between the execution price and the midpoint of the spread. These firms also maintain floor brokers on most exchanges. One firm stated that the regulatory environment was presently too uncertain for it to accept payment for order flow. These arrangements, typically referred to as reciprocal arrangements, take a variety of forms. Trade execution costs are measured both through time, for five different weeks from August 1999 to October 2000, and across different trade sizes. Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution. TFM Investment Group initiates fee per contract arrangements with several firms. As of November 30, 2000, some order routing firms were not accepting payment for their order flow from specialists.

Internalization of retail options orders takes on various forms in the options markets. The Commission expects that the exchanges will have made substantial progress towards implementation of the linkage by October 1, 2001. The Commission did not, however, require options market centers to make publicly available monthly electronic reports that include uniform statistical measures of execution quality, as is required in the equities markets. Furthermore, an order routing firm must not allow an order routing inducement, such as payment for order flow or the opportunity to internalize customer orders, to interfere with its fiduciary obligations. To make this evaluation, order routing firms should obtain reliable execution quality information in order to compare the quality of the markets to which they route their customer orders with the quality of alternative markets. The Commission published this proposal for comment. Subsequently, the ISE filed a similar rule change.

Consolidators do not typically have a direct relationship with the retail customer. Options Clearing Corporation bylaws and state laws, however, makes it difficult to trade listed options off an exchange floor. The exchanges, without admitting or denying the findings, consented to various remedial undertakings to reform and improve the options markets. At some firms, the sample was as small as three orders per day, while at other firms, the sample was as large as fifty orders per day. Over the past year and a half, the trading of listed options has undergone significant change. Staff that they did not view the reports as objective, because, in their view, the exchanges have a conflict of interest in providing their own execution quality reports. See Securities Exchange Act Releases Nos. In addition, the Commission requested comment on whether it should require that a consolidated BBO be calculated and disseminated for the options markets, thereby facilitating the disclosure of order execution practices. The results for quotes at the maximum width are consistent with those for quoted spreads.

PCX failed to execute at the best bid or offer. One firm stated that it reviews every customer order to determine whether it was executed at, better, or worse than the best bid or offer at order receipt time. The exchanges agreed to the entry of a consent decree designed to promote competition and lead to substantial reform and improvements in the options markets and in the rules of the options exchanges. As noted above, the CBOE does not use this definition of price improvement in its execution quality reports. The six exchanges that are participants in the Plan are the Amex, the CBOE, the ISE, the New York Stock Exchange, Inc. Specifically, the Phlx is considering requiring its specialists to document the specific per contract or flat rate payments the specialists are paying each order routing firm. Since August 2000, the options exchanges have taken steps to formalize their reports on execution quality. Similarly, the competition for brand recognition between large specialists operating on each exchange and the exchanges themselves may be producing positive pressure on spreads. The absence of such widening during the review period indicates that other market forces are at work.

The Staff also obtained information concerning payment for order flow arrangements during the review period from 188 specialists on the CBOE, Phlx, Amex, PCX, and ISE. Several order routing firms interviewed by the Staff stated that they find it difficult to evaluate and compare the execution quality information provided by specialists. The trend in realized spreads was up from November 1999 to June 2000, which tends to suggest that specialists were earning more per trade. The Amex, CBOE, Phlx, and PCX have started providing execution quality reports to their member firms. Consolidators are members of the options exchanges and, therefore, maintain electronic links to the various exchange floors and maintain a staff of floor brokers on each options exchange. Given that order flow payments are made by specialists and specialists are compensated based on effective spreads, the growth of payment for order flow intuitively could be expected, all other things being equal, to be accompanied by a widening of effective spreads.

This could, if utilized by order routing firms in making routing decisions, lead to enhanced quality of execution for customer options orders. Based on this information, the pie charts illustrate the percentage of customer options orders in the 53 classes that were paid for by specialists versus the percentage of customer orders in those classes that were not paid for by specialists for the months of August 1999, December 1999, March 2000, and August 2000. In fact, only one firm has significantly reduced retail customer commissions for executing listed options orders, and another firm maintains a policy to rebate payments received for order flow to customers. Four of the 24 firms reviewed maintained policies not to accept payment for order flow. While cash payments are the most common form of payment for order flow in the options markets, the Staff found that other inducements also exist. In fact, as of November 2000, the Staff is aware of only two order routing firms that have either significantly reduced retail options commissions rates or rebated the payments for order flow to their customers since the advent of payment for order flow in the options markets. Several TAG subscribers have requested that the options exchanges provide execution information to TAG, but, to date, Amex is the only exchange to provide complete data. They are most often members of the options exchanges to which they route their customer orders for execution.

Prior to August 1999, an options class often was listed on only one options exchange, making that exchange the sole venue to trade a customer options order in that class. Thus, payment for order flow arrangements and other inducements will be more transparent to investors and, therefore, subject to greater competitive pressure than is currently the case. Amex, including Intel Corp. At least one specialist provides information regarding the number of orders executed at prices inferior to the best bid or offer available on the options exchanges along with the corresponding reason. Effective spreads measure trading cost relative to the midpoint of the quoted spread at the time the trade occurred. Most payment for options order flow arrangements reviewed by the Staff between specialists and order routing firms were not in writing and the arrangements have few, if any, details other than the fact that the order routing firm will accept payments for order flow. The Staff found that the quality of these reviews varied significantly, and that the firms employed various methods to evaluate market quality such as manual review of individual orders, review of aggregate market quality data, and monitoring customer complaints.

Amex also includes additional execution quality measures, such as liquidity enhancement and liquidity premium. Instead, each exchange calculates its own best bid or offer. Amex, on the other hand, relies on OPRA data for all market information, including its own. Nearly every firm stated that obtaining executions at the best possible price and opportunities for price improvement were the most important factors in deciding where to route retail customer options orders. The Staff found that payment for order flow has had an impact on order routing decisions. These shortcomings are described below.

The Staff requested and received order routing data in 53 options classes from each firm. The Staff believes that exchanges and specialists should take steps to provide more execution quality information to order routing firms, including standardized measures of execution quality. The Staff found that 17 of the 24 firms stated that liquidity was an important factor in their routing decisions. The Staff found that internalization of retail customer options orders is not yet a prevalent practice in the options industry. International Business Machines, JDS Uniphase Corporation, Lucent Technologies, Inc. Over the past few months, Susquehanna has expanded the number of option classes included in its monthly study from its top 15 classes to its top 50 classes, and most recently, to its top 75 classes. Small retail customer orders, which are almost always executed at the bid or offer, tend to be relatively more profitable for specialists than larger institutional orders, which tend to be represented by professional traders who negotiate with the dealers for better prices.

Internalization of customer orders, as it is practiced in the equities markets, is not possible for trading listed options. The correspondence typically lists all option classes in which the firm acts as the specialist. Any rules that would establish precisely how a specialist paid order routing firms would have to be filed with and approved by the Commission. The analysis of quoted spreads yields insights into quoting behavior, including how aggressively markets compete for order flow based on displayed prices. Surpluses may continue to exist at the CBOE in accounts maintained on behalf of specialists that have decided to distribute at least a portion of the money. Payment for order flow and internalization are early products of this competition and present familiar tensions inherent in the National Market System framework. However, OEA Staff was unable to measure execution speed because information regarding the time an order was entered was unavailable. Finally, the conversion to decimal pricing may result in narrower spreads, and may impact payment for order flow. July 19, 2000, Chairman Levitt directed the staff of the Office of Economic Analysis and the Office of Compliance Inspections and Examinations to prepare a report describing current payment for order flow and internalization practices, and outlining how the practices of payment for order flow and internalization have affected order routing decisions and the execution quality of customer options orders.

Exchange rules govern the maximum allowable quote spreads. For the entire period, November 1999 to October 2000, quoted spreads have widened. Because the execution quality information provided by specialists typically is accompanied by marketing materials, order routing firms stated that they are skeptical of the objectivity of the information provided in the reports. Fee per contract arrangements may provide for payment based either on each contract sent or each contract executed. Susquehanna enlisted three professors of finance 61 to conduct a study of spreads and execution prices in the top 15 option classes in which Susquehanna was the specialist. OEA Staff also obtained audit trail data from each of the five option exchanges for one week in June 2000. The realized spread is a measure of trading costs taking into account the informational impact of the trade.

Seven CBOE specialists enter into nearly identical fee per contract arrangements with one order routing firm. Within the past several years, the exchanges have increased the maximum order size eligible for automatic execution. In August 1999, there was a large difference in quotation aggressiveness between the old and new exchange. OEA Staff measured quoted spreads for both individual exchanges and the consolidated BBO. The Staff requested order routing information in 53 options classes from each firm reviewed. Commission expressed its concern about the need for improved disclosure of execution quality in the options markets. Specialists paying for order flow typically execute trades at the BBO, so there are not significant differences in trade execution costs.

Shortly after the DPM Association was established, several CBOE specialists entered into fee for contract arrangements with an order routing firm. The Staff requested from all specialists and order routing firms reviewed by the Staff detailed information regarding any payment for order flow arrangements. Each shortcoming is described below. OPRA data feed for the information from the other four options exchanges. The quoted spread is the difference between the displayed bid and offer price. See Appendix A for a list of the 53 options classes reviewed. In the adopting release for the Order Handling Rules, Securities Exchange Act Release No. Currently, order routing firms obtain execution quality information from a number of sources.

In addition, with greater transparency in order routing patterns and order routing inducements in October 2001, firms should anticipate greater scrutiny from customers and from the public. Or, if the specialist operates on multiple exchanges, it could use the money collected from transactions in the class on the primary exchange to attract customer orders on other exchanges for classes in which it is not the primary market. Another firm passes on all payments for order flow to its customers. The conversion to decimal pricing also may result in narrower spreads in the options markets, and also may impact payment for order flow. The Staff intends to continue to closely monitor execution quality and the order routing patterns of firms that accept payment for order flow. On September 11, 2000, the Commission brought and simultaneously settled an administrative proceeding against four options exchanges. First, to prevent instances of specialists trading through a better quote on another exchange, the Commission recently approved rules designed to provide incentives to exchanges to develop linkages to limit the possibility that customer orders will be executed at prices inferior to the best available price. Staff and do not represent the findings or views of the Commission.

The report explains the reason the execution was outside the best bid or offer and indicates whether any adjustment was made by Spear Leeds to remedy the unfavorable original execution. OEA analyzed trade data to determine how the quality of the options markets changed over the same period. As noted, significant uncertainty currently exists surrounding most payment for order flow arrangements between specialists and order routing firms. Each type of firm, and the way they route retail options orders for execution, is described below. The Staff examined the internal market quality reviews of 24 firms with a significant retail options business. Over the past year, the trading of listed options has undergone significant change. As a result of these changes, specialists on multiple options exchanges began competing against each other for most customer options orders. Pursuant to this affiliation, whenever possible, the order routing firm routes its customer orders to its affiliated specialists and therefore benefits from any trading profits generated by its specialists. There are very different patterns for the time series behavior of effective spreads depending on the size of the trade and execution system used.

Approximately half of the 24 firms stated that to assess the quality of competing markets, the firm conducted a manual review of the executions obtained at various market centers. NASD rules do not require Nasdaq dealers to expose their internalized orders to competitors. The influence of payment for order flow and internalization on order routing practices and on quote competition for orders warrants ongoing attention. Many order routing firms reviewed by the Staff are actively attempting to evaluate execution quality between options markets centers. In the options markets, customer orders must be executed on an options exchange. If there are few or no competing market makers, however, or these market makers are not aggressively narrowing their quotes, a specialist will be able to trade with an even greater proportion of order flow than that guaranteed by exchange rules. As discussed above, payment for order flow is a significant source of revenue for many order routing firms. August 1999 to November 1999. TD Waterhouse Investor Services, Inc.

The lower the realized spread, the lower the revenue to liquidity providers. The CBOE, on the other hand, calculates the best bid or offer at the time the order is executed and uses that best bid or offer to compute execution quality statistics. Quoting behavior is important because it is one indication of the extent to which options specialists are competing on price for customer executions. Another firm had established reciprocal order routing arrangements with various specialists. Amex has tried to remedy this perception by providing its data to an independent third party for analysis. The options exchanges are developing execution quality reports. These four firms provided several reasons for not accepting payment for order flow.

Staff to specialists that paid them for order flow. In addition, only the CBOE and the PCX list their execution quality measures by class and by specialist. As shown in the chart below, the percentage of quotations at the maximum width followed a similar pattern. In particular, because a consolidated best bid and offer is not currently calculated and disseminated for options, there is not a uniform basis for comparable statistics. The competitive pricing process is electronic on the ISE. In August 1999, the options exchanges began to multiply list many options that had previously traded on only one exchange.

The revenue generated from payment for order flow and internalization have the potential, as seen in the equity markets, to be partly passed on to investors in the form of reduced costs. The options markets are currently working to expand capacity and develop new ways to disseminate their market information, so that, among other things, penny increments are viable in the options markets in the same way as they will be in the equity markets. For the fourteen classes analyzed, OEA Staff found that the old exchanges quoted more aggressively than new exchanges, particularly in August and November 1999. Since October 1999, many specialists have begun to pay order routing firms for their customer options order flow. Staff that they did not view the reports as objective. Four of the 24 firms maintained policies not to accept payment for order flow or other order routing inducements. Prudential Securities Incorporated, Paine Webber Incorporated, Dain Rauscher Incorporated, Charles Schwab and Co. June and October 2000. In addition, historically, order routing firms paid exchange fees to execute customer options orders; however, these fees have been reduced, eliminated, or absorbed by the exchange specialists. As shown in the chart below, for effective spreads, both old and new exchanges have executed trades at roughly comparable effective spreads since November 1999.

Realized spreads are discussed in the body of the report. Two of the firms stated that although payment for order flow is not necessarily inconsistent with providing best execution, they refrain from accepting payments to avoid even the appearance of a conflict of interest. Certain exchange rules guarantee participation by firms crossing options orders. During the course of this study, the Staff was alerted to a concern among some options dealers that proposed crosses from internalizing firms may not receive the consistent benefits of competitive pricing. The reports also lack certain information important to an analysis of execution quality. Typically, firms that internalize customer equity orders automatically execute customer orders at the national best bid or offer irrespective of their own quotations.

More detailed information is needed, and standardized information would facilitate comparison among market centers. Execution cost measures include effective spreads and realized spreads. The analysis measures spreads in three forms: quoted spreads, effective spreads, and realized spreads. First, some firms have developed methods to trade proprietarily off the exchange floor with retail customer orders, thereby generating trading profits. The OPRA Plan provides for the collection and dissemination of last sale and quotation information on options that are traded on the participant exchanges. In June 2000, more exchanges were quoting each series and, therefore, the consolidated BBO more often represented the bid from one exchange and the offer from a different exchange than in August 1999. Bear, Stearns and Co. For a more detailed review, see Securities Exchange Act Release No. Time series behavior patterns of realized spreads varied depending on the size of the trade and execution system used. The rapidly growing amount of market information, particularly quotations, produced by the options markets has put pressure on the existing system for disseminating this information to the public in a timely manner. The report also will identify trades that were executed outside the best bid or offer and show what action, if any, was taken to adjust the execution price.

Firms will be required to identify the ten venues to which the largest number of total customer options orders were routed for execution and any venue to which five percent or more of customer options orders were routed for execution. The Phlx, Amex, and PCX filed their own similar fees over the next two months. Salomon Smith Barney, Inc. OEA Staff compared execution quality measures between the old exchange and the new exchange in August and November, 1999 and February and June 2000. The Commission has stated that the duty of best execution must evolve with changes in technology and market structure. In addition, several firms have developed methods to internalize retail options order flow, which allow them potentially to profit from trading against their own retail customer order flow. As of November 30, 2000, the Staff identified at least one order routing firm that routes orders to an affiliated specialist. The practice of internalization is prevalent in the Nasdaq market where Nasdaq market makers, who often pay for order flow or are sent order flow by an affiliate, trade proprietarily against incoming customer orders. This report provides information and data as of November 30, 2000, but because the options markets are so dynamic, payment for order flow arrangements and practices are expected to change.

TAG with detailed order routing and execution information from its own system so that TAG can provide approximate results. The ISE has indicated that it also intends to provide execution quality reports to its members. Second, some firms maintain an ownership interest in an exchange specialist and in an order routing firm. Spear Leeds, upon request from an order routing firm, will provide a monthly execution quality report similar to the daily report provided by the CBOE. Other methods also exist for order routing firms to attain economic benefits similar to payment for order flow without receiving direct cash payments. Until recently, most actively traded options classes were listed on only one exchange, giving brokers no choice of routing destinations for their options orders. In such cases, the specialists decide unilaterally to send the order flow providers some amount of money from the transaction fees the exchanges make available for that purpose.

These reports are described below. Commission initiatives recently that could affect these practices, the full impact of which cannot be assessed until their implementation is complete. The PCX similarly is developing a plan that would refund all surpluses on a quarterly basis to the specialists and other market makers who paid the fee. The same specialist also may enter into different arrangements with different order routing firms. This competition may take many forms, including providing faster or more reliable executions, lower transaction costs, and increased liquidity at the displayed quotes. In addition, if the specialist on the old exchange began to pay for order flow, OEA Staff eliminated both exchanges from the analysis for subsequent time periods. There are, of course, other dimensions of execution quality, most notably, speed of execution.

These measures are important because they reflect the direct costs to investors of trading on a given options market. Commission by the exchanges to monitor for or deter such payment practices. Over the last year, specialists also provided execution quality information, packaged primarily as a marketing tool, to attract order flow. Many firms have personnel off the trading floor who monitor the quotations at each exchange and send larger sized orders to a broker on the floor of the exchange quoting the best price. In addition, the options exchanges are considering other methods to facilitate internalization. Most of the firms examined a sample of executions to determine whether the customer order was executed at or within the best bid or offer. The Commission did not, however, require options markets to make publicly available monthly electronic reports that include uniform statistical measures of execution quality, as is required in the equities markets.

The Amex and the PCX calculate the best bid or offer at the time the exchange receives an order and use that best bid or offer to compute execution quality statistics. In the proposing release, the Commission requested comment on excluding listed options from the scope of the proposed rule and on whether there are other means to improve disclosure of execution quality for listed options. Uniform qualitative measures of execution quality among the various market centers would assist order routing firms in making order routing decisions. The effective spread is a measure of the direct execution cost of the trade. The drop in October 2000 was apparently influenced by the presence of the ISE. In the options markets, internalization takes on many forms, none of which allow a dealer to exclusively interact with customer order flow without subjecting the customer orders to competition from other market participants. The reports provided by specialists do not contain consistent information, making it difficult for order routing firms to compare execution quality information among specialists.

The Staff was unable to ascertain the specifics of many payment for order flow arrangements between specialists and order routing firms. The report indicates what action, if any, was taken to adjust the price of the execution. To date, however, 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 exchanges collect the money and segregate it according to the options post where the option subject to the transaction fee is traded. Consolidators that receive payment for customer options orders are paid directly by the specialists and may pass payments along to introducing firms. In August 2000, the PCX initiated a program to provide execution quality information to order routing firms.

As the options marketplace becomes more competitive, specialists and exchanges are seeking ways to differentiate themselves as a destination for order flow and view providing execution quality information as a valuable means of marketing themselves. The Staff analyzed the following 12 classes: Amazon. Interpretation of changes in quoted spreads during the review period is complicated by the entry of the ISE into intermarket competition, and particularly by its growth in trading volume after June 2000. As shown in the chart below, realized spreads declined from August 1999 to November 1999, rose significantly from November 1999 to February 2000, and fell slightly from February 2000 to June and October 2000. These contracts are freely negotiable and differ from specialist to specialist. In fact, one order routing firm that maintains a policy of not accepting payment for order flow informed the Staff that it had not yet decided whether to accept payment for order flow from the CBOE plan, but that monies from the CBOE plan were being held in escrow pending its decision.

As of November 30, 2000, these firms have not passed along to retail customers the benefits of payments received for order flow in the form of reduced retail commissions or direct rebates. Higher percentages of quoted spreads on the maximum are consistent with less aggressive quoting. The Staff notes, however, that the exchanges have no apparent means to monitor for, and, therefore, to enforce this requirement. The reports will list the best bid or offer, as calculated by the Phlx, that prevailed at the time AUTOM received the order and identify the execution price, execution size, and speed of execution for each order. In addition, specialist firms have requested that certain exchanges create execution quality information that they can provide to order routing firms. PCX, and the Phlx. The money is then made available, on a monthly basis, to the specialist at each post. TAG provides its completed report to Amex, and Amex distributes the report to its order routing firms.

This has not, however, reduced effective spreads as would be expected in a competitive market. Dreyfus Brokerage Services, Janney Montgomery Scott, LLC, Morgan Stanley Dean Witter, and Brown and Company. Payment for order flow has had an impact on order routing decisions. Over the last year, specialists also have taken steps to provide execution quality information to order routing firms. Phlx on each option at the corresponding amount identified above. Most order routing firms reviewed by the Staff were uncertain as to how payments that they have accepted were arrived at by the specialists.

The CBOE classifies an order as price improved, if at the time the order was executed, it was executed at a price better than the prevailing best bid or offer as calculated by the CBOE. Initially, these reports only included information regarding executions occurring on the Amex. In early 2000, Susquehanna began distributing execution quality reports to order routing firms. In summary, specialists that began paying for order flow in November 1999 were not quoting as aggressively as those specialists not paying for order flow. NASD Rule 2320; NYSE Rule 123. The exchanges all have deferred to the specialist the responsibility to determine which orders to pay for and the amount of any payment to be given to an order routing firm.

Hewlett Packard, EMC, Oracle, Merck, Eastman Kodak, Exxon, and Texas Instruments. Most of these firms stated that they are continuing to evaluate the appropriateness of receiving payment for order flow. Spear Leeds stated that the reports will include information regarding executions on all exchanges. Wentworth Professor of Business, Department of Finance, Indiana University. Finally, the CBOE and the PCX provide daily and monthly reports, while the Amex provides only a monthly report. This new competition produced immediate benefits to investors, such as narrowed quotes and effective spreads. This review was conducted by the Staff of the Commission. In conjunction with this initiative, the Commission approved a linkage plan 4 in which all five options exchanges are now participants.

The most controversial of these practices is payment for order flow. August 1999, November 1999, and February, June, and October 2000. The Staff found that payment arrangements for retail options orders have resulted in significant payments to some order routing firms. All of the exchanges appear to analyze only those orders received electronically. The monthly report also shows the number of orders that received price improvement and the average turnaround time for marketable orders at each post. At the time of this report, the only independent vendor known to the Staff that is providing execution quality analyses for options executions is TAG.

The Staff intends to closely monitor execution quality measures in the options markets. Currently, there is no standardized options national best bid or offer. In September 2000, the Phlx initiated its program to provide execution quality reports to Phlx specialists and order routing firms. August 1999, November 1999, and June 2000 respectively. See Restatement 2d Agency Sec. OEA Staff also examined execution costs.

Therefore, the per contract amount actually paid for order flow does not correlate to the per contract amount of transaction fees collected. As order routing firms decide to accept payment, the specialists may retroactively pay some of those firms from the surpluses. OTC market maker, alternative trading system, national securities exchange, or national securities association. This material is available in PDF Format. Generally, payment for order flow arrangements take the form of either a monthly flat fee or a fee per contract. The exchange reports also include different measures of execution quality. Despite the decrease in execution costs from the elimination of exchange fees and execution fees charged by consolidators, and the significant revenue generated from payment for order flow, order routing firms have not, as of November 30, 2000, directly passed these savings along to retail investors in the form of reduced commissions. Some firms asserted that exchange linkages may lessen the desirability of implementing smart routing technology.

Instead of providing execution data, these specialist firms have sent correspondence to order routing firms generally discussing their policies relating to certain factors they believe would be important to an order routing firm in deciding where to route orders. Conversely, uninformed orders are orders submitted by persons possessing, at most, information generally available in the market. That specialist has little incentive, however, to use the money available to attract more order flow to the primary exchange in that class, because many of the customer orders in that class already are routed to the primary exchange without the need for payments. Over time, therefore, the quotes being matched may become wider, increasing execution costs to investors. The Phlx began collecting its transaction fee in August 2000, but had not completed a full cycle of receiving payment instructions or issuing checks. Some specialists operate on more than one exchange, and each exchange has its own automated system for handling order flow.

Order routing firms that do not accept payment for order flow generally routed their customer orders to the exchange that had the largest market share in a particular options class. Some specialists do not provide any information to order routing firms regarding execution quality. The ISE began collecting its transaction fee in December 2000. Execution quality statistics that are aggregated by specialist firm fail to identify differences between posts and among options classes that may be significant to order routing firms in making routing decisions. The PACEX report also categorizes the information by options class and by post. Cole Roesler made payments directly to the PCX on behalf of two firms to offset PCX fees incurred by these firms on the exchange. Regardless of how an order is routed to the options exchange, the process for execution is similar.

Specialists and order routing firms generally enter into agreements setting forth the amount to be paid by the specialist in exchange for a specified type or amount of order flow. These internalization methods are described below. By requiring the specialists and order routing firms to submit this documentation, specialists may be less likely to try to use funds generated from the Phlx plan to pay for order flow the specialist received at another post or on another exchange. Microsoft Corporation, Oracle Corporation, Qualcomm Inc. The Staff found that order routing firms that maintained policies not to accept payment for order flow almost never determined that market centers that paid for order flow were the highest quality markets. These firms may not find much utility in the reports because they doubt that they contain accurate and complete information. Each specialist will use the funds to attract orders in the classes of options that the specialist trades.

OEA Staff intends to continue to monitor execution costs closely. This practice is referred to as price matching. August 1999 have been muted coincident with the increasing prevalence of payment for order flow and internalization. In accepting orders and routing them to a market center for execution, brokers act as agents for their customers and owe them a duty of best execution. The Staff found, however, that reliable market center execution quality information that can be used to compare the quality of the various options market centers is limited. As a result of increased competition for options orders, practices that are commonplace in the equities markets quickly developed in the options market. Securities Exchange Act Release Nos. In the multiple trading environment, specialists on the competing options exchanges typically will promise to match the displayed prices of other exchanges. By June 2000, the difference in quote aggressiveness was smaller, but still present.

The options exchanges recently began to provide some execution quality information. Conversely, order routing firms with policies to accept payment for order flow contended to the Staff that that their market quality evaluations often demonstrated that market centers that paid for order flow were the highest quality markets. August and November 1999 and February, June, and October 2000. In addition, the Staff found that most of the 24 firms stated that speed of execution, exchange systems, and customer service were factors the firm considered in determining where to route orders. The Staff found that the number of retail customer options orders paid for pursuant to payment for order flow arrangements has steadily increased. This requires considerable deference to market forces as they shape market structure. LMM at the trading post where the funds were collected, for the LMMs use in attracting orders in the options traded at that post.

As of November 30, 2000, the Amex had collected the transaction fee for trading in July and August 2000, but had not completed a full cycle of receiving payment instructions from specialists and issuing checks in accordance with those instructions. Further, the Commission recently expressed its concern that payment for order flow and internalization contribute to an environment in which quote competition is not always rewarded, thereby discouraging the display of aggressively priced quotes. The Theme with contributions from distinguished experts in the field, discusses Probability.