WASHINGTON (HedgeWorld.com) - Harvey Pitt, the outgoing chairman of the Securities and Exchange Commission, addressed his concerns on payment for order flow in a letter to the options exchanges.
Chairman Pitt wrote to the heads of each of the five U.S. exchanges where stock options are listed, asking for an explanation of each exchange's policy with regard to payment for order flow and the internalization of order flow by member firms.
The SEC, the chairman wrote, has been monitoring this issue with growing concern.
"I am seriously concerned," he wrote, on Jan.24, "that economic inducements to order-flow providers and internalization by member firms create serious conflicts of interest that can compromise a broker's fiduciary obligation to achieve best execution of its customers' orders."
Three of the options exchanges sponsor such programs, the Philadelphia Stock Exchange, the Pacific Exchange, and the International Securities Exchange.
In an initial response to Mr. Pitt's letter, Meyer S. Frucher, chairman and chief executive officer of PHLX said that his exchange had initiated its own program only in order to remain competitive and has long urged the SEC to ban the practice. He said that PHLX will not "unilaterally disarm" and he promised a more comprehensive response within the next two weeks. He also observed that PHLX did stop such payments in July 2001, but competitive pressure forced then to resume the practice.
The Pacific Exchange is likewise unwilling to disarm. Spokesman Dale Carlson said that the PSE had received Mr. Pitt's letter and planned to respond. "We would rather that payment for order flow in all of its forms be eliminated from the marketplace," he said, but if nothing more happens than that the exchanges formally wash their hands, but the practice continues through the brokerages, than nothing will have been gained.
"The practice has been endemic for more than 20 years," and it takes many forms, not all of them obvious, he said. "A structural change" in the markets will be necessary in order to bring an end to it.
The American Stock Exchange and the Chicago Board Options Exchange each did "disarm," about two years ago, and each supports a general cessation of the practice.
"We are pleased that the SEC has begun to address this problem, and we believe that the most effective approach would be to ban payment outright in the options industry. " said Lynn Howard Reed of the Chicago Board Options Exchange. She added that the CBOE looks forward to working with the SEC to that end.
In a statement issued after he had received Mr. Pitt's letter, Amex Chairman and Chief executive Salvatore Sodano said that he, too, was pleased as the SEC's interest in the matter: "As I have consistently stated, payment for order flow is not in the best interest of investors and violates the spirit and intent of best execution requirements. Now, more than ever, we need to ensure that we are taking every possible step to restore investor confidence in the marketplace. Ending the practices of payment for order flow and internalization will be a big positive step in that direction."
The ISE, the all-electronic stock options exchange, has long been the holdout on this issue. "Our only comment at this point is that we have received the letter and we are reviewing it," said Steven M. Sears, director of research and corporate affairs at ISE, on Jan. 30.
