Breaking Down The Options Market: Payment For Order Flow - Part Two
...continued from Part One.
THE POWER OF LINKAGE
The electronic linkage system between the exchanges has reduced theamount of outright fraud in the options marketplace. However, thisreduction is not enough to appease the many critics of payment fororder flow.
These critics have repeatedly sent missives to the SECcontaining explicit examples of brokers violating their fiduciaryresponsibility in return for cash payments.
Unfortunately, the SEC has steadfastly refused to issue a ruling onthis subject. This refusal has acted as a de-facto approval of thepractice, furthering its divisive impact on the industry.
ìThis is so deeply embedded in our business that, absent something thatis really earth-moving, Idonít think there is going to be a lot of change, because the SECdoesnít feel that they have the capabilityî says Bill Brodsky, Chairman& CEO of the CBOE. ìItís like putting your finger on a balloon. Youpress on one side and something is going to come out the other side.
INTERNALIZATION & TRANSPARENCY
The only consensus that has emerged from this fractiousdebate is that it is impossible to eliminate payment for order flow in theoptions markets.
ìAny time there are multiple manufacturers trying to sellproduct down a limited number of distribution channels, there are going to beincentives offered,î says Kenneth Leibler, former Chairman of the Boston OptionsExchange. ìI donít think that you will ever eliminate these incentives.î
Frucher agrees, saying, ìyouíre never going toeliminate payment. What you really have to do is define it, control it and makesure itís transparent.î
The issue of transparency has become especially problematicin recent years. Many firms and exchanges are adept at disguising theincentives that they provide to brokerage firms. Payments of cash arefrequently compounded with other, less obvious incentives.
One popular methodis to allow the brokerage house to cross, or internalize, a larger percentageof their volume. This allows the brokerages to gain double commissions andgenerate position profits without any cash changing hands.
The combination ofinternalization with direct payment has prevented the SEC from issuing a rulingon payment for order flow.
ìPart of the problem is that the SEC has been unableto differentiate these different things sufficiently,î says Brodsky. ì Assomeone who has been in the business a long time, the difference betweentickets to a ballgame, or internalization, or a direct payment, one may be moreobvious than another, but the SEC has recognized, at least from thatperspective, that they canít sort these out.To Be Concluded In "Part Three"...
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